Redemption periods and liquidity mismatch in the investment funds market: the litigation risks

The recent announcement by the FCA of its consultation into liquidity mismatch in authorised open-ended property funds (CP20/15), has once again cast a spotlight on the risks arising from mismatches between the redemption periods offered by investment funds and the liquidity of the underlying assets.

The focus of the current FCA consultation is on funds investing directly in property, for example offices, shops and warehouses. However, over the past few years, international regulators have regularly raised more general concerns about liquidity mismatch in the open-ended investment funds market.

We know from the 2008 global financial crisis, from market reaction to commercial property funds following the UK’s referendum on EU membership in 2016, and more recently as a result of market turmoil triggered by the COVID-19 pandemic that – in times of stressed market conditions – there is likely to be an increase in both retail and institutional investors seeking to cash in or transfer assets held in investment funds, which may lead to a liquidity crisis.

Given the ongoing difficulties and interest in this area, we thought it would be helpful to share an article we published in the Journal of International Banking & Financial Law in late 2019, considering the litigation risks which may arise as a result of the mismatch between redemption periods and liquidity. We provide a detailed analysis of the potential causes of action an investor may have against various potential defendants, including: the investment fund itself, the fund manager, the depository, the fund administrator, auditors to the fund, and the investor’s own investment manager/adviser.

The article can be found here: Redemption periods and liquidity mismatch in the investment funds market: the litigation risks

Simon Clarke
Simon Clarke
Partner
+44 20 7466 2508
Ceri Morgan
Ceri Morgan
Professional Support Consultant
+44 20 7466 2948

High Court strikes out claim against banks in their capacity as lenders to investors of a tax deferral scheme

The High Court has struck out claims brought by former investors in the Ingenious Media tax deferral schemes against lending banks who advanced sums to the investors for the purpose of investing in the scheme: Mr Anthony Barness & Ors v Ingenious Media Limited & Ors [2019] EWHC 3299 (Ch).

In the context of the current wave of tax deferral scheme litigation (including in respect of the film financing schemes Samarkand, Proteus, Imagine and Timeless Releasing), the interlocutory decision in Barness provides reassurance to banks which acted as lenders to the investors in those schemes. This is particularly welcome in circumstances where investors are increasingly pursuing claims against such lenders where the independent financial advisers (“IFA”) and promoters who provided advice to investors directly have either collapsed or do not have sufficiently deep pockets.

The most important aspects of the case which are likely to be of relevance to similar claims, and more generally to financial institutions selling products on an execution-only basis, are as follows:

  1. The claimant investors in Barness sought to establish that their relationship with the banks went above and beyond a standard lending relationship, and that they were owed duties (both in contract and in tort) by their lenders relating to the suitability of the investment for which the loan was advanced. The court firmly rejected this avenue of reasoning, referring to the decision of the Court of Appeal in Green v The Royal Bank of Scotland plc [2013] EWCA Civ 1197 and of the High Court in Carney v N M Rothschild & Sons Ltd [2018] EWHC 958 (Comm) that there is no general obligation on a lending bank to give advice about the prudence or otherwise of the transaction which the loan is intended to fund.
  2. For claims based on implied contractual terms or duties of care to succeed, it remains paramount for claimants to point to very specific words or conduct. In this case, it was asserted by the investors that the lending banks had agreed (or acquiesced) to the investors’ IFA “packaging” together the investment proposition with available financing. The court found that – even if this assertion was accepted – it was insufficient to establish an implied term as to the suitability of the investment, or to find that the banks had assumed a similar duty of care in tort or had otherwise endorsed the investment.
  3. The court was unconvinced by the argument that there existed an implied “umbrella contract” based on the “private banking and wealth management relationship” between the claimants and the lenders. We have previously considered a similar (unsuccessful) attempt at such an argument advanced in Standish v RBS [2018] EWHC 1829 (Ch) in our blog post. There has been a noticeable uptick in claimants asserting the existence of an implied umbrella or overarching agreement as a vehicle by which to advance arguments based on implied contractual terms. The court’s robust rejection of such claims in this case and Standish will be welcomed by financial institutions.
  4. The court also rejected a claim that the IFA promoting the scheme had acted as the lending banks’ agent, and that the banks were therefore vicariously liable for its negligent advice. The court held that the IFA and the banks had conducted their separate businesses throughout (of providing financial advice and financing respectively), such that the activities of the financial adviser could not be said to have been an integral part of the banks’ business. Evidence regarding the close relationship between the financial adviser and the banks was submitted to no avail. Again, the court’s robust rejection of this line of argument is helpful not only in the context of other tax deferral scheme litigation, but more generally where banks act on an execution-only basis alongside an IFA.

We consider the decision in more detail below.

Background

From 2002 to 2007 a number of tax schemes were promoted under the name “Ingenious” as tax-efficient vehicles through which investors could contribute funds to a limited liability partnership (“LLP”) for investing in films/video games and set off their share of the LLP’s losses against other taxable income. HMRC did not accept that the schemes worked as intended and, following a series of appeals, the outcome for the individual investors was that they lost both the sums invested in the schemes and the anticipated tax relief (and may be exposed to claims by HMRC for arrears of tax with interest and penalties). A number of the investors have issued claims to seek to recover their losses from a range of defendants, including claims against the banks which advanced the funds to cover some (or all) of the investors’ capital contribution to the relevant LLP.

The present claims were brought by investors who borrowed sums from Coutts & Co and National Westminster Bank plc (the “Banks”). All of the claimants received independent advice on their investments in the Ingenious schemes from the same IFA.

The claims against the Banks are part of a much larger litigation brought against financial and tax advisers, the promoters of the scheme and lenders. In relation to their claims against the lender Banks, the claimants relied on three separate causes of action:

  1. Claims for breach of contract, based on terms said to be implied into contracts between the claimants and the relevant Bank. In particular, an implied term relating to the suitability of the loans (i.e. that the Banks would not provide loan finance, introduce products or allow a loan to be packaged with an investment product, unless they were suitable for the claimants having regard to their financial position, needs, objectives and attitude to risk).
  2. Claims for negligence, predicated on duties of care of a similar nature to the (alleged) implied suitability terms, owed both (a) concurrently with the implied contractual duties; and (b) in tort arising from a non-contractual assumption of responsibility.
  3. Claims alleging that the Banks were vicariously liable for breaches of duty by the IFA, on the basis that the IFA acted as the Banks’ agent.

Decision

The court struck out the contractual and tortious claims pursuant to CPR 3.4(2)(a) and granted reverse summary judgment on the vicarious liability claims pursuant to CPR 24.2. The court’s analysis is considered in further detail below.

1. Breach of contract

The claimants asserted that the term relating to the suitability of the loan (and a number of other terms) were implied into either: (a) an unwritten umbrella or overarching contract on the basis that the claimants and the relevant Bank had entered into a “private banking and wealth management relationship”; or (b) the existing loan documentation.

Umbrella contract

As to whether there was a wider umbrella agreement, the Banks submitted that the claimants had failed to comply with CPR Practice Direction 16, which requires that claims based on oral agreements and conduct must specify the words spoken and conduct in sufficient detail. The court agreed that no facts had been pleaded which supported the existence of an umbrella contract between the claimants and either of the Banks.

Having noted that not every breach of Practice Direction 16 would lead to a claim being struck out, the court considered the claimants’ argument that the umbrella contract arose on the basis of the Banks’ conduct, specifically in offering the “package” presentation of the investment and loans. In the court’s view, this did not provide the requisite support for the umbrella contract. It said there was no logical connection between the alleged “packaging” of the loans and investments, and the suggestion that the Banks offered to undertake an overarching responsibility for management of the claimants’ wealth which was over and above the particular services provided by the Banks (loans and current accounts etc.). The court likewise held that statements in one of the Bank’s internal documents that the claimants had a “full banking relationship” did not suggest that the Bank had entered into an umbrella contract to provide not only banking but also wealth management services.

The court concluded that there was no pleaded basis for the suitability terms to be implied into an umbrella contract and this was sufficient to justify strike out in the circumstances, noting that it would have alternatively granted reverse summary judgment.

Loan documentation

The court paraphrased the test for implying terms into a contract (clarified in Marks and Spencer plc v BNP Paribas Securities Services Trust Company (Jersey) Limited and another [2015] UKSC 72, although without citation in the judgment). It found that the alleged contractual duty on the Banks not to package loans with an unsuitable investment was neither so obvious as to go without saying, nor necessary to give business efficacy to the contract.

The court accepted that it was well established that a bank which sells a product to its customer is not under a (tortious) duty to advise as to the nature of the risks inherent in the transaction (Green v RBS). In those circumstances, the court could not see any sustainable case pleaded (or that could realistically be pleaded) that the suitability terms were to be implied into the contracts of loans between the Banks and the claimants.

The court therefore struck out the claims (and noted it would have alternatively awarded reverse summary judgment).

2. Negligence

As noted above, the allegation that the Banks owed the claimants a duty of care in tort was argued firstly on the basis that it was concurrent with a like duty in contract. This duty was not considered further, given the court’s rejection of the contractual claims.

Accordingly, the court proceeded to consider whether the relevant Bank assumed responsibility towards each of the claimants giving rise to a duty of care in tort of a similar nature to the (alleged) implied suitability terms. The court accepted that to find a duty of care in tort required some communication between the Banks and the claimants to the effect that the Banks were assuming responsibility for the tasks in question; and reliance by the claimants.

The claimants could not point to anything in terms of advice that crossed the line between the Banks and the claimants, but relied – once again – on the “packaging” of the loans with the investments to give rise to the duty of care. Without more, the court found this was insufficient to give rise to a duty of care. The court noted that a bank does not “assume an advisory role simply because it agrees to lend to the customer for a particular purpose” (Carney) and could not, therefore, be said to have assumed an advisory role simply because it agreed to its loans being “packaged” together with an investment. This was particularly so where there was an IFA advising the customer.

The court rejected the claimants’ attempts to draw comparisons with cases in which a duty of care had been found and reliance was not required, such as White v Jones [1995] 2 AC 207 (where a solicitor instructed by a testator was held to have owed duties of care in tort to the intended legatees). The court distinguished such cases on the basis that they related to whether an established contractual duty of reasonable skill and care can be said to be owed not only to a client of the defendant, but also to the person intended to benefit from the defendant’s advice. That was different to the present case, in which the question was whether there was a relevant duty of care at all, rather than widening the class of people who can sue for breach of duty.

The court therefore found that there were no reasonable grounds for bringing the claims and ordered strike out, noting that it would equally have granted reverse summary judgment.

3. Vicarious liability

The claimants alleged that the IFA had acted as the Banks’ agent in “introducing, explaining and advising upon the packaged investment”. The court said that the relevant question was whether the IFA was acting on behalf of the Banks, which required them to have either:

  1. told the claimants that the IFA was advising on their behalf, or otherwise held the IFA out as doing so (which was not the case, due to the fact that the loan documentation explicitly stated that the claimants were not relying on advice provided by the Banks); or
  2. used the IFA to discharge a duty to advise owed to the claimants (and the court found that there was no such duty to advise). In relation to the final claim based on vicarious liability, the court therefore granted reverse summary judgment in favour of the Banks.

An argument based on the rule in Cox v Ministry of Justice [2016] UKSC 10 which was advanced by the claimants also failed. This test expands the scope of agency to situations in which a person carries on activities as an integral part of the business activities of the principal and for its benefit. The court found that the business activities of the IFA in providing financial advice were neither an integral part of the business of the Banks, nor were they for their benefit. Despite the close commercial relationship between the IFA and the Banks, the commission paid by the former to the latter and the “packaged” presentation of the investment and the loan, each party was carrying out its own business, namely that of providing financial advice and providing banking and lending services respectively.

In relation to the final claim based on vicarious liability, the court therefore granted reverse summary judgment in favour of the Banks.

Julian Copeman
Julian Copeman
Partner
+44 20 7466 2168
Ceri Morgan
Ceri Morgan
Professional Support Lawyer
+44 20 7466 2948
Kevin Kilgour
Kevin Kilgour
Senior Associate
+44 20 7466 2584
Michael Hunt
Michael Hunt
Senior Associate
+44 20 7466 2796

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
+44 20 7466 2949

“Topping up” of Ombudsman awards through the courts not allowed: Court of Appeal overturns High Court decision

The Court of Appeal has handed down an important judgment holding that complainants who had accepted a Financial Ombudsman Service (“FOS”) determination were barred from bringing court proceedings in relation to the same cause of action under the legal principle of res judicata.

In doing so, the Court of Appeal overruled a High Court decision that complainants to the FOS would be able to accept a determination awarding them the statutory maximum award (now £150,000) and then subsequently claim for damages above that amount through the courts.

Clark v In Focus Asset Management & Tax Solutions Ltd [2014] EWCA Civ 118

The High Court decision in Clark v In Focus Asset Management & Tax Solutions Ltd [2012] EWHC 3669 (QB) (“Clark”) (please see our earlier e-bulletin here) had caused concern in the financial services industry as it had seemingly allowed complainants the opportunity to accept a FOS award in order to build a “war chest” with which to bring litigation proceedings through the courts.

The Court of Appeal decision will be welcomed by the financial services industry because it prevents complainants who accept FOS awards from having “two bites of the same cherry”. The decision also removes the uncertainty as to the finality of FOS determinations which has existed since the High Court decision in Clark was handed down because it was in direct conflict with a previous High Court decision on the issue.

The Court of Appeal’s decision leaves open the possibility that, where a complainant has two distinct causes of action, they may be able to submit one to the FOS, while bringing concurrent or subsequent court proceedings in relation to the other. Such examples are likely to be relatively rare and would in any event have already entitled parties to bring two separate sets of litigation proceedings on the established principles. In such cases, to have the court proceedings struck out, the burden of proof will lie with the respondent firm to demonstrate to the court that the causes of action of the FOS complaint and the litigation proceedings are the same. However, even if a party with two separate causes of action did bring legal proceedings after having accepted a FOS award, they would not be entitled to double recovery of the same losses.

Conflicting High Court decisions

In December 2012, the High Court in Clark decided that a party who had accepted an award of compensation pursuant to a determination of the FOS and had been paid the statutory maximum award (then £100,000, now £150,000) by the firm, could subsequently bring a damages claim through the courts to recover the full loss they had suffered over and above the FOS award.

In the earlier case of Andrews v SBJ Benefit Consultants Ltd [2010] EWHC 2875 (Ch) (“Andrews”) (which was decided on very similar facts to Clark), the High Court decided that once a complainant had accepted an award pursuant to a FOS decision, the doctrine of merger applied. This doctrine provides that once a decision has been given by a judicial body on a cause of action, that cause of action is extinguished and a second set of court proceedings for losses incurred under the same cause of action but not yet claimed cannot then be brought.

The conflict in these judgments of the High Court hinged on the finding that a decision of the FOS was a decision of a judicial body, such that the doctrine of merger would apply to its decisions. In Andrews, HHJ Barratt QC determined that the FOS was such a judicial body; in Clark, Cranston J held that it was not. The reasoning relied on by Cranston J in the High Court was that the FOS was not a judicial body because it dealt with complaints, which were distinct from legal causes of action. Accordingly, the FOS complaint had not merged into the court proceedings as they did not both concern legal causes of action to be determined by a judicial body.

The High Court’s decision was appealed to the Court of Appeal.

Decision of the Court of Appeal

Summary

Concluding in favour of the appellant financial adviser in the case, the Court of Appeal applied the doctrine of res judicata to rule that acceptance of a FOS award, for whatever amount, precludes a complainant from then bringing legal proceedings to pursue a claim based on the same cause of action.

Critical to the Court of Appeal reaching this decision were its findings that: (i) a FOS determination is judicial in nature such that the doctrine of res judicata applies to it; and (ii) Parliament’s intentions in establishing the FOS scheme under the Financial Services and Markets Act 2000 (“FSMA”) were that it should be an expeditious and cost-free means of dispute resolution for consumers and, as such, its decisions should be final. Importantly, the Court of Appeal held that nothing in the FSMA prevented the doctrine of res judicata applying to FOS determinations.

Identifying same cause of action crucial to establishing res judicata

In order for res judicata to apply, the action brought before the court must be based on the same cause of action as the complaint brought before the FOS. In the case before the Court of Appeal, this presented no problems. However, the Court of Appeal noted that there may be situations where a complainant who has accepted a FOS award might nevertheless be able to bring legal proceedings because the cause of action (or, perhaps, the type of loss) in the legal proceedings differs from that which had been considered by the FOS (even though the causes of action might arise from substantially the same facts).

In particular, the Court of Appeal noted that a complaint to the FOS might not always appear to equate directly with a cause of action where a complaint is not very well particularised by the complainant (for example, because they do not have legal advice and have simply set out facts as they see them). In such circumstances, because the FOS must give reasons for its decision, it should nevertheless be able to discern what cause of action a complaint is in fact based on, or, if not, it should investigate to establish this and formulate its decision accordingly.

Further, where res judicata is put forward to strike out court proceedings, the burden of proof in establishing that the FOS decision and the court proceedings are based on the same cause of action will lie with the financial services provider. Accordingly, the complainant will have the benefit of any doubt.

FOS as a judicial body

The Court of Appeal held that the FOS was a judicial body for the purposes of the doctrine of res judicata. In reaching that conclusion, the Court noted, among other things, that the FOS must reach its decisions on the basis of what is fair and reasonable, rather than on strict legal principles. However, the Court did not consider that this precluded the FOS from being a judicial body for the purposes of res judicata, particularly because, to be valid, a FOS decision must not be perverse or irrational, and must take (proper) account of the law.

The FOS intervened in the proceedings in order to clarify that it considered itself to be a judicial body for the purposes of the application of the doctrine of merger or res judicata.

Court proceedings only precluded once FOS determination is accepted

A FOS decision is only binding on the parties once it is accepted by the complainant. However, a decision of the FOS which is not accepted by the complainant is not binding and so the doctrine of res judicata cannot apply to it. This means that a complainant may well still seek to obtain a FOS determination in its favour, decline to accept it, and then seek to use it as evidence in its favour in court proceedings.

The courts are not likely to consider determinations of the FOS persuasive, but an adverse FOS decision (and any accompanying recommendation to pay a higher amount of compensation than the statutory maximum) may encourage firms to enter into settlements with their customers.

3. Comment

The Court of Appeal’s decision brings a welcome degree of certainty back to the finality of FOS determinations.

While there is still scope for a complainant to accept an award and then bring legal proceedings if the causes of action and/or the types of loss are different, such circumstances are likely to be limited. Financial firms may be able to take steps to avoid this occurrence by ensuring that, in their response to a complaint, all causes of action arising from the particular set of facts on which a complaint is based are very clearly identified so as to maximise the prospects of demonstrating that the FOS has taken them into account when reaching its decision.

The decision also increases certainty for firms in that, once a FOS award has been accepted, complainants cannot take the same matter to court, even if the FOS has made a recommendation to pay compensation above the statutory maximum.

Equally, this may force some complainants with high value claims to consider at the outset whether a FOS complaint is worth pursuing (notwithstanding the costs involved and the perception of the FOS as a more consumer-friendly forum) or whether litigation is the only viable option.

Hywel Jenkins
Hywel Jenkins
Partner
+44 20 7466 2510
Ajay Malhotra
Ajay Malhotra
Associate
+44 20 7466 7605
David Dowell
David Dowell
Partner
+44 20 7466 7467

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

High Court rules that Ombudsman awards may be “topped up” through court action

The High Court has decided that a party who accepts a FOS determination awarding them the statutory maximum award (now £150,000) can subsequently claim for damages above that amount through the courts.

The Court concluded the doctrine of merger does not apply to FOS decisions. This ruling is in direct conflict with a previous High Court decision (in Andrews) which held that, once a consumer had accepted a FOS decision, its cause of action merged with that decision and could not be pursued further. The firm is seeking permission to appeal this decision and it is therefore possible that it will be overruled by the Court of Appeal on appeal.

The decision may encourage potential claimants with claims of over £150,000 to seek to use the FOS process in the first instance as a means of securing an award with which to fund subsequent litigation claiming the balance of their losses. However, assuming the FOS agrees to determine a complaint likely to exceed the statutory maximum award, such claimants would run the risk that if they accept a FOS award and the recent decision is overruled or not followed, they may be barred from claiming the balance of their losses through the courts.

The Decision

In December 2012, the High Court in Clark v In Focus Asset Management & Tax Solutions Ltd [2012] EWHC 3669 (QB) decided that a party who had accepted a favourable Financial Ombudsman (FOS) decision and had been paid the statutory maximum award (then £100,000, now £150,000) by the firm could subsequently bring a damages claim for the full loss they have suffered over and above the FOS award.

Mr and Mrs Clark (the Complainants) had made a complaint to the FOS that financial advice given to them by In Focus Asset Management & Tax Solutions Ltd (the Firm) was inappropriate.  That advice had allegedly caused them losses of in excess of £500,000.

The FOS upheld the complaint and decided that the Firm should pay compensation in accordance with a formula to put the Complainants back in the position they would have been in had the allegedly inappropriate advice not been given.  However, the FOS’s award was capped at the statutory maximum of £100,000 (in January 2012 this statutory maximum award was increased to £150,000).  The FOS made a recommendation that the Firm should pay the full amount of compensation derived from the formula but warned the Complainants that they “may not be able to enforce a greater amount [than the statutory maximum award] in the courts.”  The Complainants accepted the FOS’s award but added a manuscript rider to the pro forma acceptance form stating: “we reserve the right to pursue the matter further through the civil court“.

The Firm paid the statutory maximum FOS award but did not pay the recommended compensation above this level.  The Complainants banked the cheque for £100,000 and subsequently brought a claim in the County Court for their alleged losses, giving credit for this payment.  However, HHJ Barratt QC granted the Firm’s application to strike the claim out, following the High Court decision in Andrews v SBJ Benefit Consultants Ltd [2010] EWHC 2875 (Ch).

In Andrews (which was decided on very similar facts to Clark v In Focus), HHJ Pelling QC, sitting as a Deputy Judge in the High Court, decided that once a complainant accepts a FOS decision, the doctrine of merger applied to any subsequent court proceedings brought in respect of the same facts.  The doctrine of merger provides that a party which has obtained a final judgment in a tribunal of competent jurisdiction is precluded from later recovering in court a second judgment for the same relief in respect of the same subject matter.  Andrews relied on the reasoning of the Court of Appeal in R (on the application of Heather Moor & Edgecomb Limited) v FOS and Lodge[2008] EWCA Civ 642 in which it was decided that the FOS was a court or tribunal for the purposes of Article 6 (the right to a fair trial) of the European Convention on Human Rights (ECHR).

The decision in Andrews was widely considered by legal and insurance commentators to have provided much needed clarification to the expected legal position in an area with little relevant case law.

However, in Clark v In Focus Mr Justice Cranston considered that Andrews was incorrectly decided on the issue of whether the doctrine of merger applied to FOS determinations.  Mr Justice Cranston said that the Court in Andrews had ignored an obiter statement in Heather Moor in which Rix LJ had said that the FOS is “dealing with complaints, and not legal causes of action, within a particular regulatory setting“.  This comment, in Mr Justice Cranston’s view, showed that there was a distinction between the cause of action being considered in the court case and the matter that had been determined by the FOS.  Accordingly the doctrine of merger did not apply.

Mr Justice Cranston also rejected the reasoning that the FOS should be treated as a tribunal for the purposes of the merger doctrine because it was a tribunal for the purposes of ECHR (as per the decision in Heather Moor). In addition, the Court decided that the acceptance of the award by the complainants as being “final and binding” was “final” only in the sense of being the conclusion of the FOS process rather than in the sense that the complainant could not take further proceedings.  Mr Justice Cranston said that it seemed to him that it was not inconsistent with the aims of the statutory framework of FOS for a complainant to use a FOS award to finance the legal costs of bringing court proceedings.

Interestingly, the Judge held that, if in fact the merger doctrine did apply to FOS decisions (contrary to his primary conclusion), the words written by the Complainants on the pro forma acceptance form for the FOS award (“we reserve the right to pursue the matter further through the civil court“) did not mean that they had not given their “final” acceptance of the FOS determination and would not assist them in arguing that merger had not occurred.

The Firm is seeking permission to appeal the High Court’s decision to the Court of Appeal.

It is worth noting that this decision only affects whether the Firm’s application for strike out of the claim was successful.  Even if the Complainants are ultimately successful in proving negligence, there is no guarantee that the Court will use the same formula as the FOS to determine the quantum of their loss.

Conclusions

If the High Court’s decision in Clark v In Focus is upheld, this may have the effect of encouraging complainants with claims larger than the statutory maximum FOS award to utilise the FOS in the first instance with a view to building a “war chest” of legal costs before commencing court proceedings respect of the balance of their claim.  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.

A key consequence of this judgment is that the FOS procedure can no longer be seen as an ‘alternative’  to court.  From a regulatory perspective, the FOS may therefore face a higher volume of claims from complainants with higher value claims.  This may possibly be counteracted if the FOS considers (or firms are able to persuade it) that such cases are better dealt with by the courts given their size and complexity, and should therefore be dismissed by the FOS without considering the merits (which is a ground for dismissal under DISP 3.3.4R(10)).

We anticipate that this decision is likely to have moot impact on complaints that have a value around the level of, or that may moderately exceed, the maximum statutory award. This is because the FOS may agree to determine such cases and the complainant may be keeping alive their option to pursue subsequent court proceedings.   However, quantification of financial and investment loss often gives rise to difficult issues (which may in some cases, of course, have given rise to the complaint in the first place).  The precise level of loss may not be known when the complaint is first made to the FOS.  It would be an unfortunate consequence of this decision if the FOS adopted a more cautious stance to agreeing to determine complaints and dismissed more complaints on the basis that they might exceed the FOS’s statutory limit.  This would defeat the legislator’s objective of establishing a scheme for resolving lower value financial claims quickly, informally and without recourse to the courts.

More generally, the High Court’s decision in Clark v In Focus appears to place significant weight on Rix LJ’s statement in Heather Moor that the FOS is “dealing with complaints, and not legal causes of action, within a particular regulatory setting“.  The context of Heather Moorwas a challenge, by way of judicial review, to a FOS decision on grounds that the FOS was required to determine complaints in accordance with English law but had failed to do so, instead making a decision by reference to what the FOS considered to be fair and reasonable.  Rix LJ’s statement was made in the context of distinguishing the FOS, which determines complaints by reference to its “fair and reasonable” jurisdiction, and a judge, who determines legal claims and is bound to apply the law in all its particulars.  There are, of course, strong public policy reasons for this distinction: lower-value financial claims may not merit the full vigour of the legal process and the FOS scheme provides an alternative dispute resolution mechanism to those who cannot afford (or choose not to pay for) it.  There are also strong public policy reasons for resolving such claims efficiently and informally, which the statutory framework establishing the FOS recognises when providing for a “scheme under which certain disputes may be resolved quickly and with minimum formality …”  The decision in Clark v In Focus relies on the principle that the doctrine of merger applies only to causes of action, but a cause of action is (merely) the factual situation which entitles one person to obtain a remedy from a court against another person.  It is not clear why a complaint before the FOS should not be treated as encompassing that factual situation so that the doctrine of merger does apply.  In addition, a complainant is not required to accept a FOS decision (and can instead bring court proceedings), but where he does so, it would seem to meet another aspect of public policy – the need to bring disputes to a final end – for the complainant to be barred from taking his complaint further in a different forum.

It is also interesting to note that the Judge in Clark v In Focus did not consider the fact that DISP 3.3.4R allows, but does not compel, the FOS to dismiss a complaint without considering the merits if the subject matter: (i) has been the subject of court proceedings where there has been a decision on the merits or (ii) is currently the subject of court proceedings.  This reflects the fact that the FOS’s jurisdiction to consider complaints is wider than the legal causes of action but the complaint may be equivalent to or encompass the legal cause of action in a given case.

The financial services industry is not likely to welcome the prospect that claimants can now have ‘two bites of the cherry’ nor the lack of clarity now introduced into this area until the Firm’s efforts to appeal are resolved.  In any event, given that there are now two conflicting High Court decisions, determination of the issue by the Court of Appeal would be desirable.

Simon Clarke
Simon Clarke
Partner
+44 20 7466 2508
 
Jenny Stainsby
Jenny Stainsby
Partner
+44 20 7466 2995
 
Hywel Jenkins
Hywel Jenkins
Senior Associate
+44 20 7466 2510
Ajay Malhotra
Ajay Malhotra
Associate
+44 20 7466 7605