German Federal Court of Justice defines exception to disclosure obligation relating to gross margin of a swap

Exactly five years after its landmark decision in 2011, the German Federal Court of Justice (Bundesgerichtshof, BGH) has handed down another important decision in the ongoing swap saga. Banks must normally disclose the specific amount of a swap’s initial negative market value, ie the gross margin. An exception applies if an interest rate swap aims to hedge risks arising from a corresponding loan agreement. The BGH has now explained what “corresponding” means: a loan with the same bank, on the same amount and term, hedging opposite interest rate risks. This limits the scope of the exception considerably. On a positive note, the BGH has confirmed that clients cannot claim damages if they knew about the existence of the initial negative market value but did not show any interest in its exact amount. (Judgment dated 22 March 2016, file no XI ZR 425/14)

Five years of swap disputes

Banks have known since the leading BGH decision dated 22 March 2011 (Ille)¹ that they may have to disclose the so-called initial negative market value of a swap. The BGH defines the initial negative market value as the sum of the profit and cost components structured into a swap transaction, ie roughly the bank’s gross margin. This disclosure obligation is based on an advisory agreement that banks are deemed to conclude when presenting specific investment opportunities to a client. The court believes that the existence of a negative market value reflects a severe conflict of interest for a bank whilst advising its clients.

Relying on the Ille decision, many companies, individuals and municipalities have since lodged claims for damages against banks in connection with losses incurred in swap transactions. Several appeal courts reached inconsistent conclusions on several aspects of these cases.² A large number of these disputes, including the present case, involve municipalities who had entered into swap transactions, aiming to “optimise” the interest on existing loans. In April last year, the BGH clarified several points in such a case.³ Most importantly, it held that the disclosure duty exists irrespective of the swap’s complexity. However the decision still left some questions unanswered. The BGH ruling in March answers some of them.

No disclosure obligation for swaps hedging “corresponding” loans

A small town municipality had entered into several different swaps with the defendant Landesbank, trying to reduce the burden of interest payments under several existing loans with other banks. It sought to challenge the swap transaction on the basis of the Ille decision. The defendant relied on one of the BGH’s findings last year, namely that a bank does not need to disclose the initial negative market value of an interest-rate swap if the sole motivation for the swap is to hedge risks arising from a corresponding loan agreement. It has been unclear though how exactly this exception applies, in particular what is a “corresponding loan agreement”. The BGH ruled in March that it is a loan that exactly matches the swap’s conditions:

• the loan must be given by the same bank as enters into the swap;
• the loan must already exist or be entered into at the same time as the swap;
• the swap’s reference amount must be the same as the outstanding value of the loan, or at least not exceed it;
• for floating rate loans the swap’s term must match the loan’s term; for fixed rate loans the swap’s term must be the same as the fixed-interest period, or at least not exceed it;
• the bank’s payment obligations under the swap must be aligned with the floating or fixed interest rate that the client must pay under the loan, at least in terms of partially hedging contrary interest rate risks;
• the bank must, on the same reference date:
• either take on the client’s floating interest rate based on the same underlying value (eg a reference interest rate) in exchange for a fixed interest; or
• pay to the client the fixed interest it owes under the loan in exchange for a floating interest.

In other words, the parties must, from an economic point of view, at least partially convert a floating rate loan into a synthetic fixed rate loan, or vice versa. Under these highly fact-specific conditions, the bank does not need to disclose the initial negative market value to a client.

The BGH explained that, in these circumstances, the parties to the swap merely economically change the terms of the loan. The court assumes that in such a case the client knows that the bank is pursuing its own profit interest, just like when offering an amendment to a loan agreement. Hence, the bank does then not need to disclose its margin. This reasoning reflects its justification for the disclosure obligation. The BGH regards a bank offering a swap to be in a severe conflict of interest as it both “bets” against the client and earns a profit by structuring the initial negative market value into the transaction. In the BGH’s view, a client assumes that the bank only earns a profit if the swap’s reference rate moves favourably for the bank, and a client does not appreciate that a bank also adds a margin to the swap’s structure.

No liability if client knew about the margin but showed no interest in the amount

The exception did not apply in the present case, but the outcome is still open. The BGH referred the case back to the Higher Regional Court to establish further relevant facts. Normally the disclosure obligation comprises both the existence and the amount of the initial negative market value. The bank had asserted that the client knew that the bank would earn a margin but still did not show any interest in its exact amount. The BGH confirmed that, if this was the case, the client cannot claim damages.

The rationale for this is causation. A bank may rebut the presumption of causation of loss by proving that a client would have entered into the transaction even if it had known the existence and amount of the gross margin. The BGH confirmed that a client’s absence of interest in the exact amount of the negative market value reveals that this was not a decisive factor for the client’s entering into the agreement.

In addition, the bank had asserted that the municipality entered into the swap transactions because it did not want the losses from earlier transactions to become publicly known. The BGH confirmed that this would also rebut the presumption of causation. If the client decides to enter into the swap for other reasons, then a failure to disclose the initial negative market value does not cause the client’s loss.

Comment

The BGH insists on the disclosure of a swap’s margin in normal circumstances, and, contrary to banks’ hopes, limits the exception to swaps that exactly match loans. The reasoning for the exception reveals an incorrect comprehension of swap transactions. A bank does not earn a profit if the swap’s underlying interest rate develops favourably; this is neutralised by hedging (by the bank). So the assumed conflict of interests does in fact not exist. Sophisticated bank clients know this, and they also know that banks add their margin to the swap’s structure – just as with most financial products.

The BGH’s comments on causation are very welcome though for banks. They can avoid liability if they can prove that a client knew about the existence of a margin but did not show any interest in its amount. This will depend on the individual circumstances of each case. It is thus worth investigating the exact communications before a swap is entered into. This means that many of these disputes will continue with first and second instance courts taking evidence on these points.

Another question in some swap disputes remains. The limitation period in older cases has run out – unless the bank has wilfully breached its disclosure obligation regarding the initial negative market value. The burden of proof is on the bank. Banks have argued that, before the “Ille” decision, they could not have known that such a disclosure obligation even existed. Several appeal courts have held opposing views on this point. Some have agreed with the banks’ argument;⁴ others have held that banks knew that they must disclose a conflict of interest.⁵ The BGH will have to decide this point as well.

Footnotes

<sub>1. Judgment dated 22 March 2011, file no. XI ZR 33/10, see article “German Federal Court of Justice (BGH) renders opaque judgment in misselling case regarding interest rate swaps”, EFLR May 2011.
2. See article “Disclosure obligations and swaps: An analysis of regional variations in Germany”, EFLR February 2014.
3. Judgment dated 28 April 2015, file no. XI ZR 378/13, see article “Bank must disclose initial negative market value of swap if it both advises on, and enters into, the swap, EFLR July 2015.
4. Munich Higher Regional Court, judgment dated 18 June 2014, file no. 7 U 328/13 and judgment dated 27 August 2014, file no. 7 U 1701/13; Hamm Higher Regional Court, judgment dated 21 January 2015, file no. 31 U 73/14; Cologne Higher Regional Court, judgment dated 11 November 2015, file no. 13 U 159/13.
5. Munich Higher Regional Court, judgment dated 24 September 2015, file no. 23 U 3491/14; Koblenz Higher Regional Court, order dated 5 November 2015, file no. 8 U 1247/14.</sub>