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German Court renders opaque judgment in swaps misselling case

 

27 May 2011

The BGH (22/03/2011, file No XI ZR 33/10) has confirmed the general rule that a bank must not specifically disclose the conflict of interest that results from its intention to make a profit on a product that it recommends and sells to a customer.  

Nor must it disclose the concrete amount of the budgeted profit.

However, it postulated an exception to such general rule “if the risk structure of the recommended product was deliberately engineered to the detriment of the customer so as to enable the bank to ‘sell’, directly in connection with the conclusion of the contract [with the customer], the risk assumed by the customer owing to the bank’s advice”. It held in this case that the non-disclosure of the “initial negative market value” of a “CMS Spread Ladder Swap” by the bank fell under this exception because an “initial negative market value” would imply that “the market assesses [the customer’s] risks more negatively than the countervailing risks of the [bank] that advises him”.

In the last few years various German appellant courts have rendered contradictory decisions on misselling claims based on the non-disclosure by a bank of the “initial negative market value” of structured swaps “sold” (the terminology is somewhat blurred as these are OTC contracts entered into between the customer and the bank, under which the customer is technically the protection seller) to customers (municipalities, local utilities providers, medium enterprises). The “initial negative market value” was understood as the difference between the net present values of the known stream of the bank’s future payments under the fixed leg, and the modelled stream of the customer’s future payments under the variable leg as at the moment of the conclusion of the contract.

At its first opportunity to deal with this question, the BGH overturned the Frankfurt Higher Regional Court’s (Oberlandesgericht) appeal decision of 30 December 2009 (file No 23 U 175/08) which had dismissed a customer’s claim for damages in the amount of the loss (plus interest) which the customer had incurred under a “CMS Spread Ladder Swap” (which is in effect a complex structured trade on the widening of the spread between the ten and two year EURIBOR swap rates) that it had entered into with the bank. The BGH decided against the bank on the sole ground of missing pre-contractual disclosure of the swap’s “initial negative market value”, stating that such disclosure would have been required in the light of the specific circumstances of the case, albeit without clearly explaining what these particular circumstances were.

The judgment must be read against the background of the well established BGH case-law that a bank that sells a financial product to a customer other than in the “execution only” mode is deemed to enter into an implicit investment advisory agreement with the customer. The bank must disclose any and all material facts that could reasonably impact on the customer’s decision, so as to ensure free and informed consent by the customer. Although the scope of the bank’s pre-contractual disclosure obligations is highly disputed, there has always been broad consent that the bank’s intention to make a profit does not need to be specifically disclosed as it is obvious to any reasonable person. This well established principle has recently come under attack in the light of the MiFID rules and similar concepts of German law on disclosure of inducements, basically on the ground that whether the bank earns a resale spread or pockets a commission makes no difference given the serious conflict of interest that exists and which overshadows the advisory relationship.

The BGH stated obiter that a product such as a “CMS Spread Ladder Swap”, which it characterised as risky, with a highly complex structure requires the provision of detailed and comprehensible information to the customer: the bank must not only explain in detail all elements of the formula for the calculation of the variable payments and their concrete effects under any conceivable developments of the yield curve, but also that the respective risk/reward profiles of the parties are unbalanced insofar as the customer’s exposure is unlimited whereas the bank’s exposure is limited to the amount of the fixed interest payments. The customer would have to be brought to a level of knowledge which is basically identical to that of the bank.

The BGH left open whether the bank had actually complied with these requirements as it held that non-disclosure of the “initial negative market value” of the swap was sufficient to justify the customer’s claim. It found that the fundamental conflict of interest that results from the bank holding the opposite side of the customer’s trade was not solved through passing on the risks and rewards immediately to other market participants through hedging transactions. Passing on the bank’s position under a swap to the market was only possible because the contract was structured in a way that “the ‘market’ – according to the available simulation models – attaches a negative value to the risk taken by the [customer]” and accordingly “a positive value to the chances of the [bank]”. From the perspective of the customer, the bank’s recommendation would be seen in a different light if only he knew that the contract “is structured in a way that currently the market assesses [the customer’s] risks more negatively than the countervailing risks of the [bank] that advises him”.

Following this analysis, the BGH emphasised that the conflict of interest that triggers the disclosure requirement stems neither from the bank’s intention to make a profit nor from the concrete amount of the budgeted profit, but exclusively from the fact the “the risk structure of the recommended product was deliberately engineered to the detriment of the customer so as to enable the bank to ‘sell’, directly in connection with the conclusion of the contract [with the customer], the risk assumed by the customer owing to the bank’s advice”.

Comment

It is debatable whether the judgment is confined to a highly specific set of facts (as presented to the BGH) or has broader impact. It is fair to say that the underlying perception that the bank’s position under the specific trade would be passed on to the market “directly in connection with the conclusion of the contract” and that the “initial negative market value” would be an expression of how “the market” assesses the odds of the specific trade does not at all reflect the way that banks’ exposures under structured swaps of that kind and size are usually hedged: there is usually no (micro) hedge through selling a mirror trade in the market, but rather a (macro) hedge through a bundle of forwards or futures that lie over an entire portfolio, meaning that there is no guarantee that the bank will in the end really make a profit on the single trade.

There is no such thing as a “market” for the specific trade, and the customer could not himself mimic such trade through buying and selling a bundle of forwards and/or futures with the required notional amounts and tenors. Through the macro hedge the bank acts basically as an intermediary that buys forwards and/or futures in volume so as to resell them en detail – thereby enabling the (retail) customer to take a position in the (wholesale) market – just as any other merchant buys and sells any other marketable commodity. The “initial negative market value” is, under normal circumstances, not a “market value” but a “model value” derived from the bank’s proprietary valuation model. This is (in a nutshell) based on the assumption that EURIBOR rates in the future will equal the convexity-adjusted forward rates calculated from today’s EURIBOR swap curve, where the outcome depends on the volatility of the forward swap rate and the correlation between the forward swap rate and the forward interest rate, which requires certain proprietary assumptions and estimates.

The “initial negative market value” is far from distorting the odds of the customer’s position (ie “the risk structure of the recommended product” that basically only depends on the development of the yield curve) in favour of the bank, but is just the resale spread that the (retail) customer has to pay for the possibility to take his position in the (wholesale) market through a bundle of forwards and/or futures. The BGH evidently mistook the net present value of the customer’s future payments as per the moment of the conclusion of the contract according to the bank’s internal valuation model for “the market’s” assessment of the odds of the trade. It will be interesting to see how the BGH will further develop its jurisprudence on this and whether it will find a reasonable balance between the general rule (no obligation to specifically disclose the intention to make a profit and the profit margin) and the exception. In the meantime there will be legal uncertainty.

Further Information

The European Finance Litigation Review is a quarterly publication on recent developments in the finance litigation and regulatory sector in key European jurisdictions.  For more information please contact Amy Edwards amy.edwards@alleovery.com.

 

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