In its judgement dated 22.03.2011 (reference number: XI ZR 33/10), the BGH for the first time delivered an opinion on interest rate swap agreements, which had attracted much attention by the public. No other judgement by the XI. civil court of appeal has attracted as much attention in recent years. The practical consequences of the judgement could be far-reaching. "You will cause a second financial crisis, if you state in the judgement that the bank is not allowed to realize a profit or that it should inform thereof" 1 , warned the counsel of the bank concerned in the oral proceedings. Things are not quite that bad, nevertheless, the judgement should give financial service providers cause to check their own sales practices. In the following, we would like to point out some areas you might want to give particular attention to.
Swap agreements, which are used to secure risks arising from a core transaction (such as any interest rate fluctuation from a loan transaction), have become discredited in recent years for being used as speculative instruments without a corresponding underlying transaction. Small and medium-sized businesses and local authorities in particular concluded such agreements with financial service providers. The scope of transactions concerned by the BGH's judgement is, however, still unclear at the moment. A hearing before the financial committee of the German parliament on 06 April 2011 was also unable to produce reliable data2.
The current BGH judgement centred around a CMS Spread Ladder Swap, which had been concluded for a fixed term and referred to a purely fictional nominal value. The bank undertook to pay the client the fixed amount of 3.0 % p.a of the reference amount during the entire term. The client undertook to pay a variable interest rate, which was calculated – subject to further levers and strikes – by determining the difference between the underlying CMS interest rate indicators (so-called spreads). The spread is dependant on the development of the reference interest rates (specifically: 10-year-EURinterbank- swap-rate and 2-year-EUR-interbank-swap-rate). Both payments were offset against one another by means of a framework agreement, so that only the difference had to be paid.
The swap's construction meant that the bank's risk was limited to 3.0 % p.a. of the reference amount from the outset, whilst the client's risk was theoretically unlimited. The spread developed badly for the client, so that he suffered significant losses.
The BGH's judgement
The BGH sentenced the bank to reimburse the loss suffered by the client. The judgement is based on a breach of the duty to provide information pursuant to the underlying consultancy agreement. In particular, the court ruled that the investor should have been informed about the initial negative market value of the product. The BGH, however, also established further noteworthy principles, which should be taken into account.
Investor specific advice
According to the so-called Bond judgement, a consulting bank is obliged to provide investor and investment specific consulting services3. In order to provide investor specific consulting services, it is necessary to inquire into the investor's level of knowledge, experience and investment objectives, including the purpose of the investment and the investor's readiness to assume risks. This duty has also been codified under supervisory law for investment service companies and is also taken into consideration in the private law relationship between investor and bank within the scope of consultancy services. This duty to enquire can only be waived if the consulting bank is already aware of the relevant circumstances, for instance as a result of a long-term business relationship with the client or his previous investment behaviour.
As the swap's mode of action and its calculation had been explained to the investor and he had been informed of the "theoretically unlimited risk", the lower court4 had decided that the investor had been prepared to assume the risks. However, the BGH is of the opinion that in the case of a "highly complex structured financial product" such as the CMS Spread Ladder Swap agreement in question, it cannot be assumed that a client concluding a transaction is actually prepared to assume high risks. If the willingness to assume risks is not explicitly inquired into, the bank – according to the BGH – has to make sure that the client has understood all the aspects of the risks involved with the financial product before the investment decision. Otherwise, the bank cannot assume that its recommendation complies with the client's degree of disposition to assume risks. The bank would have had to ensure that the investor knew that the risk of loss was not limited in value and was not purely theoretical, but rather was definitely a realistic possibility if the interest rate difference developed accordingly.
Whether the BGH's statements comply with reality, is questionable. Firstly, why is the notification of a "theoretically" unlimited risk not sufficient? As ultimately a risk is theoretical and the scope of the risk clearly results from the calculation method of the swap which was disclosed. Secondly, in the past the BGH has accepted that clients do not need to be informed about unlikely risks5. An unlimited risk is ultimately unlikely, as the interest rate difference will remain within realistic limits. In practice, such considerations are of little use, as it will be necessary to deliberate on how to deal with the BGH's propositions.
The BGH's ruling shall only apply to "highly complex structured financial products". Therefore, the question arises as to what exactly the BGH considers to be a highly complex structured financial product. The court has not answered this question, so that the matter cannot be resolved at present. At best, the BGH's statements concerning the investor's previous investments could be seen as an indication. Previously, the investor had concluded two interest rate swap agreements, in which the bank endeavoured to pay the investor a variable interest rate based on a nominal value (six-month-EURIBOR and three-month-EURIBOR), whereas the investor in exchange undertook to pay the bank a fixed interest rate of 5.25% or 5.29% based on the reference amount. The BGH does not seem to deem such swaps "complex" and does not deem them comparable with spreadladder- swaps concerning structure or risk. The BGH also seems to accept the fact that agreements concluded in order to secure actual interest-bearing loans are an indication for a simpler structure.
Practical note: So long as the BGH has not clearly stated what the term "highly complex structured financial products" designates, the bank should not assume that the client's willingness to conclude a transaction also implies his disposition to assume the risk. The client's readiness to assume the risk for a specific, individual transaction should therefore always be inquired into and documented (!). The previous investment behaviour of the client should also be documented, as it can indicate his readiness to assume risks.
It is to be recommended that risk information be incorporated into information materials (or after the entry into force of the law on investor protection and functional improvement into the product information sheet (Produktinformationsblatt – PIB)-§ 31 Abs. 3a WpHG n.F.) more clearly than previously.
Investment specific advice – Sufficient risk information
The BGH also raised specific concerns as to whether the investor had been sufficiently enlightened in terms of investment specific advice, without ultimately actually answering the question in this specific case. In this point as well, the BGH introduces new requirements for "highly complex structured financial products". From the court's point of view, it is not sufficient merely to explain the necessary calculation steps in order to work out the variable interest rate. The BGH demands that the bank inform the investor that the risk is not purely "theoretical", but that depending on the development of the spread, it can be real and ruinous. In particular, the BGH demands that the bank explicitly informs the investor if the risk-reward ratio between the participants of the interest rate bet is unbalanced: Whilst the client's risk is unlimited, the bank's risk – irrespective of its related hedging transactions – is limited from the outset, as the structure of the swap limits the bank's risk to a specific interest rate.
Practical note: In this point also, the BGH takes the bank's duty to inform the investor more seriously than most of the lower courts. This likewise means that risk information should be incorporated into information materials more clearly (or after the entry into force of the law on investor protection and functional improvement into the product information sheet (Produktinformationsblatt – PIB)-§ 31 Abs. 3a WpHG n.F.). If the risk-reward ratio is unbalanced, this should be highlighted unambiguously and documented accordingly.
Investment specific advice – Initially negative market value
It was eagerly awaited what the BGH's opinion on the bank's duty to inform about its income margin would be. It is encouraging that the BGH has stated in its judgement that a bank – if it sells its own investment products – is not in principle obliged to disclose that it achieves gains with such product. Hereby, the BGH has at least established a general principle for banks' fixed price transactions. It highlighted obviousness of the conflict of interests6. The bank's interest in achieving gains was obvious, therefore the client did not need to be explicitly informed thereof.
However, the BGH's judgement goes a step further and states that a duty to inform differing from this general principle shall arise, if in addition to the mere interest in achieving gains other specific circumstances are relevant. In the matter in dispute CMS Spread Ladder Swap, the BGH judged the negative initial market value to be such a specific additional circumstance which the client should be informed of7. In particular, the BGH objects to the fact that the swap was structured in such a way that the market assessed the risk-reward-ratio of the contracting parties at the time of the conclusion of contract to amount to 4 % in favour of the bank. This market assessment – positive for the bank, negative for the investor – enables the bank to cover its expenses by entering into offsetting counter trades (hedging arrangements) and to realize a profit. The BGH states that, in the case of such a negative market value, the investment advice received by the investor is put into a different perspective, if he knows that the complex interest rate calculation formula was structured in a way to make the market assess his risks more negatively than the risks of his bank – which is advising him. He should have been informed of this conflict of interests.
Practical note: The fact that the BGH states that it is a bank's duty to inform an investor of the negative market value of an investment is probably the most significant problem for structured (finance) products. If one applies the principle vigorously, it is to be recommended that the bank explicitly informs the investor of every structured (finance) product with an initially negative market value. This will probably primarily concern products, which the bank secures by hedging arrangements and therefore has to cover its costs through the profit margin gained in the on-sale.
In a nutshell, it should be remembered that when selling structured (finance) products the client's disposition to assume risks should always be inquired into and documented. The client's previous investment behaviour should also be recorded.
Risk information should be clear and unambiguous. In particular, information should not be toned down by restricting it to theoretical indications. If a structured (finance) product has a negative initial market value, which enables the bank to meet its costs by carrying out a hedging transaction and to realize a profit, the client should be informed hereof.
1. Deutsche Bank fürchtet Milliardenforderungen", Handelsblatt vom 08.02.2011
2. http://www.bundestag.de/bundestag/ausschuesse17/a07/anhoerungen/2011/048/index.html 3. BGH: judgement dated 6.7.1993 - XI ZR 12/93
4. OLG Frankfurt a. M.: judgement dated 30.12.2009 - 23 U 175/08
5. BGH, judgement dated 25.4.2006 AZ: XI ZR 106/056
6. BGH, NZG 2010, 623
7 Contrary to all the previous OLG Stuttgart, WM 2010, 756
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.