The financial crisis and ensuing losses suffered by counterparties to various structured product transactions has provoked an outbreak of "misselling" cases. A number of cases have been heard by the English Courts but proceedings have also been brought in jurisdictions across Europe, including Germany. This alert looks at the outcome of cases in Germany and England and the lessons that can be learnt from the differing trends in these jurisdictions.

Germany - An overview

It is a long-standing principle under German law that a bank, when approached by a customer about investment advice and when giving such advice, will be deemed to enter into a separate contract for advisory services with such customer. As a result, the bank is obliged to inform the customer of all facts material to the customer's investment decision. Whether a bank has reached the required degree of disclosure will depend upon the facts of the case and the complexities of the underlying product. This article discusses one in a long line of actions brought against Deutsche Bank by various midsize corporates and municipalities in connection with spread ladder swaps entered into with Deutsche Bank.

England - An overview

Cases before the English Courts have examined the construction of contractual documentation, common law duties and the regulatory overlay, under the Financial Services and Markets Act 2000 ("FSMA"). It is worth bearing in mind that regulatory action can often open the floodgates to civil claims and financial exposure to clients may be more likely to crystallize in the context of a settlement with the regulator.

The leading case in this area is the case of JP Morgan Bank v Springwell Navigation Corp in which the Court held that under the terms of its contract the bank was not under any duty of care to advise its client as to the suitability and appropriateness of investments and that no misrepresentation claim could be made. Thus, under English law it is in principle possible to construct a purely execution only style relationship and for financial institutions not to accept obligations to advise or ensure suitability.

The English Court has tended to take a stricter line that enshrines the principle of freedom to contract and for parties to strike a bargain (subject to mandatory regulatory protections) as to the scope of responsibilities of the financial institution.

Germany – Recent Decision on Misselling involving Deutsche Bank

In a decision handed down on 22 March 2011, the German Supreme Court (Bundesgerichtshof – the "Court") held Germany's largest bank, Deutsche Bank (the "Bank"), liable for misselling. The Court awarded some EUR 540,000 in damages against the Bank in an action brought by a German manufacturer Ille Papier-Service GmbH ("Ille"). The Court found that the Bank had failed to adequately advise Ille of the risks associated with a financial product, a so-called "CMS spread ladder swap", which the Bank had recommended. The Bank had, in particular, not disclosed to Ille that at the date of trading, the swap had a negative market value of EUR 80,000 for Ille. The decision has been long-awaited, both because it provides important guidance on the scope of disclosure duties of banks vis-à-vis their customers under German law and because it is only the first in a long line of actions brought against the Bank by various mid-size corporates and municipalities in connection with spread ladder swaps of this specific type to reach the Court.

The decision imposes strict duties of disclosure and advice on banks doing business in Germany.

The Court found that, in 2005, the Bank proposed that Ille enter into an interest swap transaction with the Bank governed by a German law master agreement, the Rahmenvertrag. The standard Rahmenvertrag does not contain a Non Reliance provision equivalent to the 2002 ISDA Master Agreement's optional provision however no reference is made to any form of non reliance provision in this preliminary press release of the case. Under this swap, the Bank had to make semi-annual interest payments at 3 percent on a reference amount of EUR 2 million., i.e. EUR 60,000 every six months, for a period of five years. At the same intervals, Ille was to make payments based on a fixed interest rate of 1.5 percent on the same reference amount; after the first year, Ille's payments were computed on the basis of a floating interest rate. This floating interest rate was calculated on the spread between the 10- and 2-years swap rates on EURIBOR basis, called "CMS 10" and "CMS 2", respectively. The formula used for the floating rate was "interest rate of previous period + 3 x [strike – (CMS 10 – CMS 2)]"; the "strike" was fixed at 1.0 percent, but would decrease over time to 0.85, 0.7 and ultimately to 0.55 percent and the floating rate could not go below zero. When meeting with Ille, the Bank had warned Ille that there could be a situation where the spread decreased so much as to result in Ille having to make payments rather than receiving any. The Bank also advised Ille that Ille's loss exposure was "in theory without limit". At the time of trading, the swap had a negative market value of about 4 percent of the reference amount, i.e. about EUR 80,000. The Bank had structured the swap in such a way in order to hedge its own risk exposure in the market. However, the Bank did not disclose this fact to Ille.

It is a long-standing principle under German law that a bank, when approached by a customer about investment advice and when giving such advice, will be deemed to enter into a separate contract for advisory services with such customer. As a result, the bank is obliged to inform the customer of all facts material to the customer's investment decision. This obligation will increase with the degree of complexity of the financial product. More specifically, the bank has to inform the customer of the risk exposure in clear terms. Where this risk exposure may lead to materially adverse consequences for the customer, this needs to be communicated clearly. The risks must not be downplayed or described in a vague fashion. In essence, the customer has to be put in a position where his understanding of the risks associated with the financial product is the same as that of the bank.

In its decision, the Court made clear that CMS spread ladder swaps are highly complex and risk laden products which require the bank to provide the highest degree of advice, even where – as in the present case – the customer is being represented in the negotiations by a person holding a business degree. However, the Court did not say whether the Bank's risk disclosure had met these standards, or whether the Bank met the standards sufficiently when it described Ille's risk exposure as "in theory without limit". Instead, the Court based its decision on the fact that the Bank had violated its duties under the separate deemed advisory contract with Ille when it did not reveal to Ille that the swap had been designed to have a negative initial market value of EUR 80,000. The Court made sure to add that this does not mean that banks have to inform their customers that they seek to make profits when they recommend their own products; the Court conceded that this motive was obvious and did not require any disclosure vis-à-vis the customer. That said, the Court found that the situation is different where a bank wilfully engineers the odds of a product to run against the customer for the purpose of being able to hedge its own risk, as the Bank was found to have done in this instance due to the initial negative market value of the trade. Because the Bank had not disclosed this fact, Ille had a right to effectively rescind the contract and to claim back any payments made under the swap.

The full reasoning of the Court is not available yet. However, a few significant ramifications can already be identified.

  • Where a bank sells to its customer a product such that the interests of the bank and the customer run contrary to each other – as in the case of this swap –, and where the bank has structured the product so as to work in its favour, the bank must disclose the relevant factors to the customer. In particular in spread ladder swaps like the one in this case, the bank must disclose any negative initial market value which it may have worked into the swap.
  • Products such as spread ladder swaps or other highly complex derivative instruments will require a bank to comply with very high standards of advice and disclosure. Indeed, the Court requires banks to in essence put customers in a position where they understand the risks associated with the product as well as the banks themselves do.
  • The fact alone that the customer's representative holds a business degree will not per se relieve a bank of determining whether the customer actually understands the particular product on offer. Rather, the bank must ascertain in each individual case if the customer understands the risks.
  • Banks are under no general obligation to disclose the profits which they make when they sell their own products.

With this decision, the Court has provided some significant clarification of the scope of the German law advisory and disclosure duties applicable to banks when providing their customers with financial products proposals. While these are strict, it does not follow from this latest decision that spread ladder swaps, or derivatives products in general, cannot be sold in Germany. It is also not the case that banks must be continually wary of being sued for misselling in all cases. While some commentators have argued that this is in fact the case, the findings of the Court are based on a very specific set of facts. Most importantly, the key element – i.e. the negative initial market value – will not be found in every swap, let alone every financial product. In addition, whether the customer can rely on the argument of misselling will always depend on the factual circumstances of each individual case, including the information made available to the customer and the specific knowledge that the customer, or its representatives, have about the product in question. When sued for misselling, it will therefore always pay off to first carefully scrutinize the underlying facts.

The English

Under English law, the key issue is what duties the financial institution has agreed to accept under its contract or terms of business with its client and how it has characterised its client. A firm may categorise its client as an advisory, discretionary management or execution only client. The duties that the firm owes to its client, both from a regulatory and common law perspective, will depend on this categorisation. The client's degree of sophistication and categorisation for regulatory purposes are further considerations in assessing the duties owed to the client.

The precise legal basis of claims brought by clients will of course vary according to the particular facts. Recent claims have, however, tended to involve allegations of breach of contractual duty of care, the implying of terms into the contract with the firm and misrepresentation. In some cases where a relationship has been set up as an execution only relationship, clients have subsequently sought to contend that the firm assumed a duty to advise based on the conduct of the personnel within the firm who in fact provided advice to the client and thereby assumed a duty to advise.

The JP Morgan Bank v Springwell Navigation Corp case illustrates the approach taken by investors seeking damages for negligent advice. The investors in the Springwell case were successful businessmen categorised as sophisticated nonprivate investors for the purposes of their relationship with JP Morgan. These individuals, acting through a company, invested in a portfolio of debt instruments linked to reference bonds issued by the Russian Federation. When Russia defaulted on certain of its financial obligations in 1998, the value of the portfolio collapsed. The claimant argued that JP Morgan was in breach of its duty of care to advise it on which investments were appropriate, that JP Morgan was prevented from relying on certain disclaimers contained in the contractual documentation and finally that JP Morgan was liable for negligent misstatement.

The investors' claim failed, the Court holding that JP Morgan owed the claimant no duty of care to advise it as to appropriate investments and that the relevant contractual terms prevented any representations being made, obviating the misrepresentation claim. Of crucial importance was the absence of an advisory duty of care arising from the contractual documentation and the fact that the classification of the claimant as a sophisticated non-private investor was a precondition to its participation in the relevant investments. The contractual documentation showed that the parties specifically contracted upon the basis of a trading and banking relationship which negated any possibility of a general or specific advisory duty.

More recently these types of issues have been considered by the English Court in the case of Titan Steel Wheels Ltd v Royal Bank of Scotland. The client in this case claimed that RBS had, in breach of its duty, advised the client to purchase derivatives products which were unsuitable for the client. The terms of business stated that RBS did not act as the client's advisor and that it provided an executiononly service. The Court upheld the contract, ruling that RBS acted on an executiononly basis and effectively excluded any duty to the client to advise it as to the merits of the derivatives products in question.

Product documentation will include disclaimers of liability so that the issuer of the documentation will exclude liability for the accuracy of the information contained in the documentation. Disclaimers may be effective in excluding liability, although where fraud is proved they are unlikely to be enforceable. The effectiveness of a disclaimer was upheld in the case of IFE Funds SA v Goldman Sachs International.

The most recent case in this area is the case of Cassa di Risparmio della Repubblica di San Marino v Barclays Bank Ltd (9 March 2011) in which the Claimant alleged that Barclays had induced it to purchase certain structured notes, and subsequently to agree to a restructuring of the notes due to representations made to it that were fraudulent or which Barclays had no reasonable grounds to believe were true. Reinforcing the trends in earlier cases the Court found in favour of Barclays and against its client. The Court's reasoning was based partly on findings of fact, against the Claimant's allegations that certain misrepresentations had been made but also on legal grounds as to whether, for example, statements made in relation to default risk could be found to be the basis of a misrepresentation claim at all.

While the Deutsche Bank case may be regarded as being made on particular facts, the high standards expected of banks by German Courts may be contrasted with the position in England where the Courts have tended to take a strict line and hold banks responsible only in respect of what they have expressly committed to the clients to do.

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.