In the years preceding the financial crisis, more and more private clients began to invest in increasingly complex and riskier financial products in the search for yield.

Following the subsequent market turmoil, those investors have sought to recover their losses from the firms by whom they were sold the products. Investors commonly claim they had not understood the complex products in which they had invested, that they were, as a recent judgment put it, “led by the nose like a lamb” into investments far too risky for financial ingénues like themselves.

As with claims by investors classified as market/eligible counterparties, such arguments have formed the background against which (largely unsuccessful) claims against firms for misrepresentation, negligent misstatement and breach of a common law advisory duty of care have been brought.

Another cause of action often relied upon by private investors is breach of statutory duty under s 150 of the Financial Services and Markets Act 2000 (FSMA) for losses caused by breaches of the Conduct of Business (COB) rules and the successor Conduct of Business Sourcebook (COBS) rules. In this regard, the recent judgments in Michael Duthie Wilson, PS Trustees Ltd v MF Global UK Ltd, GNI Limited (in Member’s Voluntary Liquidation) [2011] EWHC 138 (QB) and Bank Leumi (UK) plc v Wachner [2011] EWHC 656 (Comm) have illustrated the difficulties that sophisticated private customers have experienced in sustaining a s150 claim based on allegations of incorrect client classification, and so are welcome news for financial institutions.

The theme that has emerged from these judgments is that it is critical for firms to ensure there is a genuine belief that a customer’s classification is justified and the reasons are documented (rather than treating client categorisation as just a form-filling exercise with a predetermined outcome).

The background

In MF Global, Wilson brought proceedings in his personal capacity and as trustee of a pension fund; the corporate co-trustee of the fund was the second claimant. The claimants opened accounts on an execution-only basis with the defendants (financial intermediaries, brokers and derivatives traders) to enable Wilson to trade directly in various investment products including contracts for difference (CFDs) and futures and options. The claimants suffered losses of £1 million, for which they considered the defendants were liable.

In Bank Leumi, the claimant bank sued for sums owed after closing-out the open positions of the defendant customer, Wachner (who was a successful businesswoman). In her counterclaim Wachner sought to recover losses caused by trading foreign exchange products, known as reverse knock-in options. The trading facilities which Wachner set up with Leumi were on an execution-only basis and she was classified by Leumi as an intermediate customer under COB. Under Leumi’s internal policies, this classification permitted her direct access to dealers in the bank’s dealing room.

Claims for misrepresentation and negligent advice

In both cases, the courts rejected Wilson and Wachner’s claims for misrepresentation and negligent misstatement (and additionally breach of an advisory duty of care in Wachner’s case). Echoing the court’s approach in Springwell v JP Morgan, the court in MF Global analysed the nature of the advice in the context of the description of the basic nature of the parties’ relationship in the relevant contracts as execution-only and non-advisory.

The court concluded that these contractual terms were of “fundamental importance”. Similarly, in considering claims that Leumi breached COBS 9.2.1R regarding the suitability of recommendations, the court noted that in analysing the regulatory context, the contractual non-advisory terms of business must be considered.

The inconsistency between Wachner’s claim under COBS 9 and the contractual backdrop assisted in defeating this claim. The courts in MF Global and Bank Leumi relied on Springwell to hold that the “no reliance, no representation” terms of business of the firms operated as a contractual estoppel from any claims of misrepresentation and breach of duty of care.

Section 150 FSMA claims for incorrect client classification

The primary thrust of Wilson and Wachner’s claims was that they benefitted from a statutory cause of action under s 150 of the FSMA, as they were incorrectly classified under the COB rules in place at the time as intermediate customers and, in Wachner’s case, as an elective professional client under the successor COBS rules.

The investors argued that they were consequently denied regulatory protections, particularly with regard to suitability and risk, available to individuals classified under COB as private customers (and, in Wachner’s case, as retail customers under COBS). They were therefore entitled to damages under s150. The courts rejected the investors’ claims. In doing so they made the following points:

Scope of the duty to classify a client

In MF Global, the court emphasised that the appropriate classification test with which the firm had to comply was to take reasonable care, in accordance with previous authorities Spreadex Ltd v Sekhon [2008] EWHC 1136 (Ch) per Morgan J, at 134 and Maple Leaf Volatility Macro Volatility Master Fund v Rouvroy [2009] EWHC 257 (Comm).

Where an investor challenges the firm’s classification process under COB 4.1.9R, the court ruled that it did not need to assess the customer’s “correct classification” separately and objectively. Instead, the court must consider whether the firm took reasonable care in determining that the client had sufficient experience and understanding to be classified as an intermediate customer, as prescribed by COB 4.1.9R(1)(a). The court will not consider the issue with the benefit of hindsight: ” … looking at what happened subsequently and saying that was disastrous trading, therefore [the investor] must have been classified incorrectly, is not the right approach”. [244]

In MF Global, the court held that the defendants complied with COB 4.1.9R. The classification of Wilson was based on a system carefully designed to elicit information from the client and provide warnings which enabled the firm to ensure it took reasonable care in classifying the client and recording the outcome. The court also noted that nothing in COB 4.1.9 required the firm to interview or to meet with the client.

COB client classification rules permitted firms discretion in their processes

Both Wachner and Wilson criticised the firms for referring to them as intermediate customers in communications before the firms had received their formal consent to be treated as intermediate customers. Wilson alleged that the three steps required by COB 4.1.9R to classify a private customer as an intermediate customer (being a written warning, time to consider implications and informed consent) should have taken place prior to MF Global referring to Wilson’s preliminary classification.

The court concluded that MF Global had adopted standard best practice of classification in the market at the time. The court recognised that Leumi had adopted a similar process consisting of a two-stage procedure of a preliminary classification and a final classification. Crucially, both stages took place prior to conducting designated investment business with the customer as required by COB 4.1.4R. This was the only timescale imposed by COB on this issue. The court found that firms therefore had discretion to organise the format and sequence of their communications with the customer, including by adopting a two-stage process.

Breach of internal standards that are higher than those required by the legal obligations did not establish a lack of reasonable care

In both cases the courts recognised that COB 4.1.10G (which sets out four criteria which firms should consider in taking reasonable care to classify a client as an intermediate customer under 4.1.9R) “merely indicates” that, in establishing it has taken care in classifying a customer, a firm will need to have regard to “one or more criteria set out in COB 4.1.10G”. As a result both Wilson and Wachner were prevented from drawing any support for their cases from MF Global’s and Leumi’s internal compliance manuals, which required employees to satisfy themselves on all four criteria; the internal manuals were irrelevant to the task of determining proper classification as there was no “legal obligation to ‘score’ on all four criteria”.

Firms should note, however, that a failure to comply with their own internal policies might well be considered an aggravating factor by the FSA should the firm face enforcement action.

Where an investor was correctly categorised before November 1, 2007, a firm was entitled to use the grandfathering procedure

Wachner failed to demonstrate that, after November 1, 2007, when COB was superseded by COBS, Leumi had become aware that she no longer fulfilled the criteria which had applied to her initial categorisation as an intermediate customer in 2005. Wachner argued that Leumi was subject to a requirement to take “appropriate action” under COBS 3.5.9R, which might include reclassification, to review her status.

The court disagreed; because Leumi’s classification of Wachner was correct under the test noted above, Leumi could avail itself of the MiFID grandfathering procedure under COBS TP 1.3G. It was entitled to treat her as an elective professional client without further steps.

The court held that to give rise to a s 150 claim, Wachner had to prove a breach of COBS 3.5.9R or COBS TP 1.3G, i.e., a failure to reclassify her despite the fact it was aware she no longer fulfilled the conditions on which she had been classified in 2005 as an intermediate customer. It was insufficient for Wachner to argue that, had Leumi taken reasonable care, it ought to have been aware of that.

Comment

In efforts to recoup their losses, the investors, Wilson and Wachner, considered (in hindsight) that such risky investments were inappropriate. A substantial obstacle to a successful claim was their classification as intermediate customers (under COB) and subsequently elective professionals (under COBS). It was perhaps unsurprising, therefore, that they sought to attack the correctness of these classifications.

On the facts, the firms were able to defeat the claims. Such claims will be more easily dismissed where robust compliance checks are in place surrounding client classification, with careful documentation being paramount. The cases further remind firms, following Springwell v JP Morgan, of the importance of contractual “no reliance, no duty of care” provisions.