Germany: New Decision On Bank's Duties Regarding Interest Rate Swaps

Executive Summary The 11th senate of the German Federal Supreme Court again had to deal with the duties of a bank recommending interest rate swap agreements. In this context, the German Federal Supreme Court re-affirmed on 22 March 2016 – XI ZR 425/14 – its position that a bank dealing with a customer interested in the conclusion of an interest rate swap has a core duty to advise this customer. In this context, the bank also has to disclose to its customer a negative market value of the interest rate swap at the time of the conclusion of such swap.

The background of the dispute is interest rate swaps which have been entered into by a German municipality on the basis of which the municipality accepted to pay flexible interest rates against fixed interest rates to be paid to the bank. Prior to entering into such interest rate swaps, the bank did not disclose to the municipality the negative market values of such interest rate swaps. The interest rate swaps provided for a negative market value of 2.9% of the reference amount of such swaps.

The court of first instance (Cologne), to some extent, found in favour of the claiming municipality. The Cologne Court of Appeal dismissed the bank's appeal but granted leave to a further appeal to the German Federal Supreme Court.

The German Federal Supreme Court now overruled the Court of Appeal's judgment and referred the matter back to the Cologne Court of Appeal. This overruling judgment became necessary since the Cologne Court of Appeal did not sufficiently take into account submissions from the bank, according to which the claiming municipality entered into the interest rate swaps in the awareness of negative market value of such swaps.

In doing so, however, the Federal Supreme Court reiterated its position, according to which a bank has a duty to advise the customer about a negative market value at the time of the conclusion of the swap (see decision of the Federal Supreme Court of 22 March 2011, XI ZR 33/10). However, this duty to disclose is not based on the duty of the bank to advise its client about advantages and disadvantages of the relevant financial product, but on a conflict of interest, based on the fact that the bank is not only selling a specific product to a customer, but if said product provides for a negative market value, then the bank usually takes the counter position in the open financial market.

However, the German Federal Supreme Court also made it clear that such duty to disclose a negative market value does not exist if the interest rate swap is entered into in connection with a specific loan agreement. For such a connection between interest rate swap and loan agreement, however, it is necessary that the bank appears on both sides, as lender under the loan agreement and counterparty under the interest rate swap. Further, the reference amount of the interest rate swap needs to be equivalent to the amount of the loan agreement. Further still, variable and fixed interest rates under the interest rate swaps and the underlying loan agreement shall be of a kind that the interest rate swaps on the one hand and the loan agreement on the other hand are part of one economic financial transaction and opposing interest rates (fixed and flexible interest rates under the interest swaps and the loan agreement) hedge each other.

A bank's duty to advise its customer in this way is a German specialty in banking matters. Therefore, it has to be emphasised that prevailing judgments in German financial disputes provide for the bank's duty to advise its customer about pros and cons of financial products, based on the assumption of an oral advisory agreement entered into between bank and customer if the bank's customer is seeking the bank's advice on such products, which is regularly the case.

Regarding the question of disclosure of negative market values, the German Federal Supreme Court does not base such duty on such advisory agreements, but on the assumption of a conflict of interest for the bank. The German Federal Supreme Court has emphasised in various decisions that a bank that not only recommends an interest rate swap to its customer, but is also the contractual counterparty of its customer in such a swap transaction, finds itself in a conflict of interest position: like in a bet, any loss of the customer in such a transaction goes to the benefit of the bank and vice-versa.

These circumstances are aggravated if the bank's interest rate swap, because of its structure, provides for a negative market value, since the bank regularly hedges its risks out of the interest rate swap; such a hedge, however, will only work in the bank's favour if the market assesses the risks of the customer as higher than those of the bank (see German Federal Supreme Court, decisions of 22 March 2011, XI ZR 33/10 and 20 January 2015, XI ZR 316/13).

The potential negative market values of interest rate swaps have become a hot topic in the European lending market. Banks and customers should therefore take this decision into account when they are entering into such linked transactions (loan agreements and interest rate swaps). In particular, financial institutions need to consider how best to document that the customer has been advised properly before entering into such transactions, unless the interest rate swap transactions are closely linked to the loan agreements and all interest rates are equivalent to each other.

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.

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