Financial Derivatives: Investments or Bets?

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KEY POINTS  The law on derivatives is still under development.  Statistical modelling is the only way to value structured instruments; the results are just as important for the client as for the bank.  The legal characteristics of derivatives differ from those of contracts of sale.  Sellers of derivatives should not be protected by caveat emptor.

Author Julian Roberts

Financial derivatives: investments or bets?

While enormously successful, derivatives are still relatively new entrants to the financial markets. Despite a number of decisions reaching back to 1989 (classic leading cases were Hazell v Hammersmith, [1991] 1 AER 545; Procter & Gamble v Bankers Trust (SD Ohio 1996)), basic principles of the law are still not settled. How do derivatives differ from traditional forms of investment such as stocks and bonds? Are the duties of disclosure more onerous? Given that most derivatives are in some sense more complex than other investments, what does understanding them actually involve?

Two recently decided European cases (CRSM v Barclays [2011] EWHC 484 (Comm) in London, Ille Papier v Deutsche Bank XI ZR 33/10 in the Bundesgerichtshof, Germany’s highest court) have now come closer to answering these questions. Both cases concerned derivatives originated by investment banks and sold directly to the plaintiffs. CRSM is an Italian savings bank; it lost €70m when the entire value of a Collateralised Debt Obligation (‘CDO’) (a credit security) was wiped out. Ille Papier is a Mittelstand company selling hygiene articles for hotels and commercial sites. It lost € ½m on an interest rate swap.

The defendant banks valued both deals at inception using statistical models, but in neither case did they reveal the valuation to the client. As subsequently became clear, in the Ille case, the deal was worth € 80,000 (4 per cent of notional) to the bank at the date of inception. In CRSM, the bank had set a significantly higher price – certainly in excess of 10 per cent, probably in the region of 20 per cent. In both cases the defendant banks booked these values as profits at the time the deals were made.

The courts took markedly different approaches to these facts.

The German Supreme Court recently decided that an interest rate swap was a bet, and that the bank should have disclosed its internal model valuation to the client.

This directly contradicts the latest decision of the Commercial Court in London.

In CRSM, Hamblen J took the view that Barclays had given its client all requisite information; in view of its various contractual disclaimers and warnings, the defendant would not have been liable even if it had left any gaps – caveat emptor. The claim therefore failed.

In Ille, by contrast, the court decided that Deutsche Bank and its client were on opposite sides of a serious conflict of interest. By not revealing that it had structured in profits at inception (the ‘initial market value’), the bank was in breach of its duty under German law to avoid conflicts of interest as far as possible, and to disclose any that were unavoidable.

Ille’s claim therefore succeeded.

In the CRSM case, the Commercial Court

one is probably more useful as a starting point for the next steps in clarifying the law.

MISREPRESENTATION OR FAULTY ADVICE? The German law on investors in financial instruments possesses components which do not apply in England. In particular, the German courts take the view that a duty to advise arises whenever a bank enters discussions with a client about investing a sum of money (see the leading case of Bond, XI ZR 12/93). This happens irrespective of who takes the initiative, and the client’s privilege is not (or at least was not for the purposes of Ille Papier) conditional on her being ‘retail’ (in terms of MiFID 2004/39/

"The German courts take the view that a duty to advise arises whenever a bank enters discussions with a client about investing a sum of money." had the advantage of copious expert evidence and, at four weeks in all, a very full hearing.

The Bundesgerichtshof, which is the third and final instance, sat for all of one hour (as is its normal practice). However, it could draw on the papers from the trial and the appeal in the courts below (not that these hearings will have been longer than one or two hours either), together with reports of numerous similar cases and the accompanying academic discussion. The English judgment runs to 566 paragraphs, the German one to 43.

In the event, neither judgment is very satisfactory, but the reasoning in the German

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EG). A duty to advise is not, of course, the same thing as a fiduciary duty, which does not apply to transactions in financial instruments unless specifically agreed.

The consequence is that while English and American cases on mis-selling usually turn on alleged misrepresentations by the bank, German decisions centre on whether the advice was sound. However, even though a duty to advise sounds more demanding than one not to misrepresent, this makes little difference in practice. German courts readily rule that lack of advice was not causative because the investor would have been able

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to make her own judgment. Whether one treats it as misrepresentations being protected by disclaimers, or as faulty advice being rendered immaterial by the knowledge and experience of the investor, the result is the same. The English courts have applied caveat emptor; the Germans have pointed to the sophistication of investors. On a typical set of facts, it has hitherto been very difficult for investors in derivatives to recover losses in either jurisdiction (see, in England, Bankers Trust v Dharmala, [1996] CLC 518; Springwell Navigation v JP Morgan Chase Bank [2008] EWHC 1186 (Comm); for Germany, see, inter alia, the lower court decisions in Ille Papier).

With the Ille Papier decision, however, this

set of strikes ranging over the maturity of the deal, it also included ‘term sheets’ with comments on the sorts of risk involved in interest rate speculation. Among other things, the term sheets emphasised that the potential losses associated with the swap were ‘theoretically infinite’. Deutsche Bank also supplied the client with a spreadsheet for calculating the sum due on any particular payment date, as determined by current interest rate data.

Despite all this documentation, the banks in neither case supplied the results of their internal valuation exercises – even though this was admitted to be the basis of its own contemporaneous accounting.

"A model valuation describes a phenomenon in a probabilistic manner." now seems set to change, at least in Germany.

There are three main issues which arise here, and they are common to all debates in the law of derivatives. They are: i) the status of model valuations, ii) the legal nature of derivatives contracts, and iii) the place of derivatives as a matter of public policy.

VALUING DERIVATIVES WITH STATISTICAL MODELS It is not the case that derivatives have been sold without information. Quite the contrary: the documentation for derivatives is notoriously bulky. In the case of credit derivatives, the documentation is mainly legal, though it does also include spreadsheets for the reference entities, specifications of attachment and detachment points, credit agency ratings and so on. In the CRSM case, it also included something called a ‘Quantitative Credit Relative Value Indicator’, a proprietary model developed

by Barclays. Despite being described as quantitative, the model does not appear to have done more than produce a rough rank order between reference entities; certainly it was not a valuation in cash terms.

The documentation for Ille’s interest rate swap was rather more slender, but apart from the contract itself, which specified a complex

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In both CRSM and Ille, the banks devoted a great deal of energy to explaining why, in their view, the internal valuation would not have been relevant for the client. They described how it was based on a model.

Models were not the same thing as market prices. Models involve using statistics to draw inferences from the past, but such inferences were never more than a ‘prognosis’.

They depended on assumptions which are more or less arbitrary, and they were, like all projections into the future, fallible. A particular danger was revealed by the financial crisis: models can significantly understate risk. Prudent traders scorn ‘mark to model’ values and are ultimately only satisfied with ‘mark to market’. All investment decisions, as Hamblen J accepted, were based on opinion, and under those circumstances it was best to trust experienced experts. In the end, this stayed closer to ‘real world or actual probability’. Thus, in the ‘real world’, the AAA rating conferred on CRSM’s deal by S&P was a better guide than any values dreamed up by computers and statisticians. (As is well known, Credit Rating Agencies escape liability for their ratings by describing them as ‘opinions’.) Ultimately – and this point is regularly emphasised in derivatives disputes – the ‘opinion’ that finally counted was that

of the investor herself, unencumbered by the illusion of numbers.

Although in CRSM the court was convinced by this, the German court was not – rightly so, because the argument is bogus.

Even though it may be used to produce one, a model valuation is not a ‘prognosis’.

The fact that in any particular case a model, under subsequent market development, comes out ‘wrong’, does not disprove what the model is saying. A model valuation describes a phenomenon in a probabilistic manner. That is different from a deterministic description, but is no less scientific and objective. A model-derived value is analogous to saying that, for the casino, operating a roulette wheel is worth 1.35 per cent of the stakes wagered.

Assuming the wheel is mechanically perfect, this remains true whether or not the house wins on the next throw; it is a description of the existing objective characteristics of the wheel, not a forecast about what will happen next. Modelling derivatives is no different in principle – it is just that working them out is far more demanding, and the assumptions are less certain. And just as the ‘edge’ given by the probabilistic structure of the wheel is an uncontroversial indicator of the casino’s cash flow, so also is the value generated by modelling a derivative. To say that ‘opinions’ are to be preferred in this context is like appealing to the gambler’s superstitions. There is nothing ‘real world’ about them, however rooted in experience.

The model value was obviously essential, the German court concluded, and given that no ordinary investor could hope to work it out herself, the bank was under an obligation to disclose it.

BUYERS OR BETTERS? The next issue concerns the legal character of derivatives.

It is not hard to see that derivatives look a lot like bets or insurance. In the AngloAmerican world, however, this similarity has been pushed firmly under the carpet since Robin Potts’ much-cited 1997 opinion for ISDA on whether credit derivatives might count as gambling or insurance. Potts’ answer, at the time, was negative. This was welcome news for the derivatives industry, not

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least because both gambling and insurance entail enormous regulatory burdens.

It has to be said, however, that Potts’ arguments are not very convincing. (The opinion is only available to members of ISDA, which means it has scarcely been tested in the literature. See, however, KimballStanley, Connecticut Insurance Law Journal 15, 2008:1.) Certainly the Bundesgerichtshof, along with a number of lower courts in similar cases, had no doubt that Ille’s interest rate swap was a bet (‘Zinswette’). In view of this, the bank’s duties were not restricted by the principle of caveat emptor. In particular, the zero-sum structure of a bet – what one party wins is identical to what the other party loses – generates a direct conflict of interest which must be disclosed. That, concluded the court, was best done by revealing the deal’s negative initial pricing (the ‘house edge’, in casino terms).

Regrettably, the German court was cursory in describing why this should be so.

One aspect, however, is as follows. Typical market transactions are all contracts of sale.

With contracts of sale, conflicts of interest are only incidental, because normally both sides increase their ‘utility’ as a result of the exchange (I want the drink more than the cash I use to pay for it; the vendor wants my cash more than he wants to hang on to the drink). Buying and selling are beneficial because they increase the overall sum of utility: there is always a bilateral gain.

With zero-sum games, however, this does not apply: the loser’s purely negative utility cancels out the positive utility on the side of the winner. There is no overall gain in utility.

The principle of caveat emptor recognises that buying and selling are, in the aggregate, beneficial. Market efficiency relies on buyers being motivated to bargain for optimal prices.

Absent fraud, mistake, compulsion and so on, ‘paying too much’ is a subjective issue for the buyer alone, not a failure in the system.

This does not apply to gambling and wagering, however. A bet is a zero-sum game, not a purchase. There is no reason of policy to shift all the price risk on to one of the parties, as in caveat emptor. A better is not a buyer (‘emptor’). In a bet, putting the client at a disadvantage is not – as some German banks

have argued – the same thing as including a ‘profit margin’ in the price for a purchase. The structure of sale contracts is fundamentally different from that of bets. The conflict of interest between the parties is not, as it is in a sale, transformed into a bilateral gain in utility. It remains just that – a naked conflict.

At least in the context of banking, the German court has now decided, this conflict has to be disclosed – quantitatively.

In normal gambling, putting the other party at a disadvantage by secretly manipulating the odds is called cheating.

In all legal gambling, it is fundamental that the wager should either be equal chance, or,

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Biog box Julian Roberts practises at the bar in London and Munich and regularly appears for clients in derivatives disputes. Email: julianroberts@tenoldsquare.com

– derivatives can be used for hedging, but in all other cases they involve an open risk exposure. For Ille, visiting a casino would have been a cheaper way of ‘optimising’.

From the bank’s perspective, on the other hand, derivatives are an excellent way of generating risk-free profits. As the German court pointed out in Ille Papier, the ‘negative market value’ achieved by manipulating the derivative’s risk structure can be realised directly through selling onwards to other counterparties. Furthermore, this process can be repeated whenever the deal shows signs of going sour, because the ‘restructuring’ which the client will then

"With zero-sum games, however, ... there is no overall gain in utility." failing that, the odds must be transparent.

If a swap is in reality a bet, then disclosing any ‘structuring’ of the odds would indeed seem to be a necessary consequence (as I have argued in ‘Finanzderivate als Glücksspiel?’, DStR 2010: 1082-1087).

PUBLIC POLICY AND THE PLACE OF DERIVATIVES The complexity of derivatives is probably one reason why there has been little discussion, at least in the legal world, as to whether derivatives are a legitimate form of business at all. In addition, the way in which derivatives are marketed has, if anything, increased their obscurity.

For example, derivatives are often spoken of as if they were a ‘purchase’ or an ‘investment’. As we have noted above, they are no such thing; a party to a derivative acquires risks and chances, but no substantive values.

A further common suggestion is that derivatives are a prudent adjunct to normal business transactions. CRSM, indeed, was induced to buy CDOs in the context of a deal to borrow money for its consumer finance subsidiaries. It was suggested to Ille that interest rate swaps would ‘optimise’ cash flow in relation to its existing commercial loans. This was a meaningless suggestion

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be offered yields further opportunities for profitable manipulation of the risk structure. In the CRSM case, Barclays freely admitted that this sort of structuring and restructuring was ‘the basis of the CDO business’, and, it would seem, the court saw nothing wrong in that. As far as the client is concerned, however, like a gambler seeking to recoup losses with further gambling, restructuring merely compounds the baleful effects of the ‘house edge’ and, ultimately, hastens disaster.

In view of all this, it is hard to see what the wider economic benefits of derivatives are outside the rather special case of hedging.

Looked at in the abstract, losses from speculative derivatives freed up liquidity which would otherwise have remained dormant. In concrete terms, however, many of these losses have fallen on SMEs, municipalities and local commercial banks; diverting liquidity from them towards international investment banks does not seem to make obvious sense. The final consequence, all too often, has been that taxpayers and local economies have had to pick up the ticket.

The German decision that model-derived values must be disclosed, should serve to put off anyone but the most determined gambler – and that is no bad thing. 

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