Financial Derivatives: Investments or Bets?

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Spotlight

SPOTLIGHT

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

Butterworths Journal of International Banking and Financial Law

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

June 2011

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