UK: Highlights of Recent Developments in Banking Law

Investor´s statutory right of action for bank´s alleged breach of IMRO rules
Last Updated: 3 May 2002

in short...December 2001 Issue No. 17

In Australia & New Zealand Banking Group Ltd v. Cattan & Anor (2 August 2001), the Court has highlighted the significant degree of care required when classifying customers for investment business. Although the requirements of the SROs relating to customer classification were merged as from 1 December 2001 within the FSA Conduct of Business Rules, the case remains of general relevance to future customer classification.

The bank sued for losses incurred by the defendant customer as a result of trading in emerging market debt (EMD). The customer, C, alleged that although he had entered into the trades, he did so as a result of the bank improperly categorising him as non-private investor, in breach of the IMRO Rules, and that he did not possess the knowledge and experience to be so classified. In reality, he asserted, he should have been treated as a private investor to whom the bank owed a duty of care to ensure that he did not enter into deals which he did not understand and which were inherently so risky that they were not suitable for a person of his standing and means. Therefore, C argued that he was not indebted to the claimant and had a counterclaim for losses made during his unsuccessful trading, pursuant to section 62(1) of the Financial Services Act 1986 (see now Section 150 of the Financial Services and Markets Act 2000).

Under the bank’s procedures, no private individual could be accepted as an investor in EMD.

Under Rule 2.1 of Chapter II, Section 2 of the IMRO Rules, a firm must take reasonable steps to establish whether a customer is a private or non-private customer. A firm may treat a customer as non-private, if:

  • It believes on reasonable grounds that the customer has sufficient experience and understanding to waive the protections provided for private customers.
  • It has given a clear written warning to the customer of the protection which he will lose, including any right of action under Section 62 FSA 1986 for breach of any IMRO rules.
  • The customer has given his written consent after a proper opportunity to consider the written warning, unless the customer is ordinarily resident outside the UK and is reasonably believed not to wish to consent in writing.

Before reaching any conclusion about whether a customer has sufficient experience and understanding, firms must consider whether, on the basis of information known about the customer and/or any representations made by the customer, he understands the nature and suitability of the investments and has sufficient experience to assess the suitability of the relevant transactions.

After hearing lengthy cross-examination, the court concluded:

  • C was introduced to the bank by the Deputy Governor of the Central Bank of Jordan.
  • C displayed considerable knowledge of EMD, including information of interest about Algerian debt which the bank’s officers did not know. C was a well-informed man who knew about at least part of the EMD market and the sort of factors which affected its value.
  • Discussions with C at the first meeting included discussion about other parts of the EMD market, such as the sovereign debt of Gabon and Sudan which were very specialised sectors of the market and about which C talked in an informed way and to a degree of familiarity beyond the norm.
  • Throughout his career, C had had a reasonably high level of dealings with bankers and government officials in relation to the financing of large and important projects.
  • C presented himself as an intelligent, sophisticated, well-connected and urbane individual, who knew his way around the international financial circuit.
  • In relation to earlier similar trading through a corporate vehicle, C had displayed keenness to open the relevant trading account as soon as possible and was impatient with form filling.
  • C understood emerging market risk in leveraged structures and was generally conversant with international capital markets and different types of investment products.
  • Although a risk warning letter was sent to C after certain trades had been carried out, this was a technical breach of the IMRO rules. C wanted the trades to be carried out and showed no desire to come out of his positions subsequently. He continued to hold investments until after they had gone sour.

A right of action under Section 62(1) FSA 1986 only exists if the investor can show that he has suffered loss as a result of the breach of an SRO’s rules.

The market had turned against C and margin calls made. The relevant debt was then re-scheduled and C was invited to consider his position. He was faced with a relatively unattractive choice of closing-out and sustaining a loss or persisting with the investment in the hope of getting his money back and making a profit. In order to do the latter, he was offered the opportunity of entering into a deferred purchase agreement whereby he was "credited" with the amounts he had already paid by way of principal and margin call but undertook other obligations contained in the agreement. After a period of reflection, C returned the agreement duly signed. However, problems persisted and eventually the bank was forced to bring proceedings for monies due under the agreement.

The Court considered that any breach of the IMRO rules in respect of customer classification had not caused any loss. Even though C had to be treated as a private customer until the formalities, including a risk warning letter, had been completed, he should and would have been advised not to enter into the transaction. However, had he been given that advice, he would have rejected it. It was clear that C was anxious to enter the trades as the market was favourable at the time and if the bank had refused to make the trades then the same trades would have been made subsequently, and there was no evidence before the Court to show any difference in price in C’s favour. Therefore, whatever the breach, whether of IMRO rules or indeed of any duty of care, C had suffered no recoverable loss. Furthermore, the loss sustained did not arise directly from the trades, but rather from the subsequent agreement under which he agreed to buy restructured debt. It could not be said that any breach of duty (statutory or otherwise) gave rise to the losses which he had suffered under the agreement.

Undue influence

Barclays Bank v. O’Brien revisited

In Royal Bank of Scotland Plc v. Etridge (No. 2) and other appeals (12 October 2001), the House of Lords redefined the doctrine and effects of undue influence as between wives providing security, banks lending to their husbands on the basis of that security, and solicitors advising banks, husbands and wives.

Clear guidelines have emerged which will bring legal certainty to existing transactions and enable banks to avoid being fixed with notice of undue influence in the future.

Eight appeals were before the House of Lords. Each appeal arose out of a transaction in which a wife (W) had charged her interest in the matrimonial home to a bank as security for the indebtedness of her husband (H), or indebtedness of the company through which H carried on business. W then asserted that she had signed the charge under the undue influence of H. Seven of the appeals concerned the applicable principles in these circumstances. In each case, the bank sought to enforce the charge signed by W. In each bank’s claim for possession, W raised a defence that the bank was on notice that her involvement in the transaction had been procured by H’s undue influence.

The eighth appeal concerned a claim by W for damages from a solicitor who advised her before she entered into a guarantee obligation.

When is the bank put on inquiry?

The House of Lords reviewed the case of Barclays Bank Plc v. O’Brien [1993] 4 All ER 417, and determined that a bank was put on inquiry whenever W offered to stand surety for H’s debts. Their Lordships considered that the Court of Appeal had erred in holding that before a bank was put on inquiry, it was necessary to prove in each case that the transaction was on its face not to the financial advantage of W, and that there was a substantial risk that, in procuring W to act as surety, H had committed a legal or equitable wrong which entitled W to set aside the transaction.

A bank would also be put on inquiry where W became surety for the debts of the company, the shares of which were held by W and H, even when W was a director or secretary of the company. Such cases could not be equated with joint loans.

Steps to be taken by banks

A bank could be expected to take reasonable steps to satisfy itself that the practical implications of the proposed transaction, had been brought home to W, in a meaningful way. Provided a suitable alternative was available, banks ought not to be compelled to hold a personal meeting with W.

Ordinarily, it would be reasonable for a bank to rely on confirmation from a solicitor, acting for W, that he had advised W appropriately. The position would be otherwise if the bank knew that the solicitor had not duly advised W or if the bank knew facts from which it ought to have realised that W had not received the appropriate advice. In such circumstances, the bank would proceed at its own risk.

Content of legal advice

In the present case, it was not for the solicitor to veto the transaction by declining to confirm to the bank that he had explained the documents to W and the risks which she was taking upon herself. If the solicitor considered that the transaction was not in W’s best interest, he would give reasonable advice to W to that effect. At the end of the day, however, the decision on whether to proceed was the decision of W and not the solicitor.

Their Lordships disagreed with the Court of Appeal, where it had said that if the transaction was "one into which no competent solicitor could properly advise W to enter", availability of legal advice was insufficient to avoid the bank being fixed with constructive notice.

Scope of the responsibilities of W’s solicitor

As a general proposition, the scope of a solicitor’s duties was dictated by the terms, whether expressed or implied, of his retainer. As a first step, the solicitor would need to explain to W the purpose for which he had become involved. He would need to obtain confirmation from W that she wished him to act for her in the matter and to advise her on the legal and practical implications of the proposed transaction.

The content of the advice required from a solicitor before giving the confirmation sought by the bank would, inevitably, depend upon the circumstances of the case. Typically, the advice a solicitor could be expected to give should cover the following matters as the "core" minimum:

  • An explanation of the nature of the documents and their practical consequences for W;
  • Identification of the seriousness of the risks involved, including discussion of (i) W’s financial means and her understanding of the value of the property being charged; (ii) whether W or H has any other assets out of which repayment could be made if H’s business should fail.
  • A clear statement that W has a choice, including discussion of the present financial position, the amount of H’s indebtedness and the amount of his overdraft facility.
  • Verification that W wishes to proceed, with confirmation given to the bank only with W’s authority.

The solicitor’s discussion with W should take place at a face-to-face meeting, in the absence of H.

The solicitor should obtain from the bank any necessary information. If the bank failed for any reason to provide information requested by the solicitor, the solicitor should decline to provide the confirmation sought by the bank.

Independent advice

Their Lordships then turned to the question of whether the solicitor advising W, had to act for W alone, which was a novel question.

A balancing exercise was appropriate for determining whether the solicitor should act for W alone, or whether the solicitor should be permitted to act for H or the bank as well (provided the solicitor was satisfied that that was in W’s best interests and satisfied also that that would not give rise to any conflicts of duty or interest).

Their Lordships held that the latter was preferable. The advantages attendant upon the employment of a solicitor acting solely for W did not justify the additional expense that would involve for H. When accepting instructions to advise W, the solicitor assumed responsibilities directly to her, both at law and professionally. If, at any stage, the solicitor became concerned that there was a real risk that other interests or duties might inhibit his advice to W, he should cease acting for her.

Agency

Where a solicitor had accepted instructions to advise W, but failed properly to do so, W had a remedy in damages against the negligent solicitor. But what was the position of the bank which proceeded in the belief that W had been given the necessary advice?

In the ordinary case, deficiencies in the advice given were a matter for W and her solicitor. The bank was entitled to proceed on the assumption that the solicitor advising W had done his job properly, unless it knew or ought to have known that that was not so.

Obtaining the solicitor’s confirmation

Returning to the steps which a bank should take when it had been put on inquiry and in particular the protection afforded by the fact that W had been advised independently by a solicitor, their Lordships stated as follows:

  • The bank should take steps to check directly with W the name of the solicitor she wished to act for her. To that end, in future, the bank should communicate directly with W, and not proceed with the transaction until it had received an appropriate response directly.
  • It should become routine practice for banks, if relying on confirmation from a solicitor for their protection, to send to the solicitor the necessary financial information. What was required would depend on the facts of the case.
  • Exceptionally, there might be a case where the bank believed or suspected that W had been misled by H or was not entering into the transaction of her own free will. If such a case occurred, the bank should inform W’s solicitor of the facts giving rise to its belief or suspicion.
  • The bank should in every case obtain from W’s solicitor a written confirmation to the effect mentioned above.

The above steps would be applicable to future transactions.

In respect of past transactions, the bank would ordinarily be regarded as having discharged its obligations if a solicitor acting for W in the transaction, gave the bank confirmation to the effect that he had brought home to W the risks she was running by standing as surety.

In Short ... highlights current legal developments. It is not a substitute for proper advice. © Gouldens December 2001

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