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Disclosure obligations: swaps and municipalities

Germany's highest court (BGH) has rendered yet another important decision on banks' disclosure obligations relating to swap transactions.

The case concerned several interest rate swap transactions between a small municipality in North Rhine-Westphalia and a former state-owned Landesbank.

The case attracted considerable attention in Germany because it was the first to be decided by the court that involved a municipality. The full judgment is not yet available. The court, however, has issued an official press release.1 This usually provides a good indication as to what can be expected from the full judgment because it is typically drafted with the help of members of the court. According to the press release, the BGH found that a bank that provides advice to, and enters into a swap transaction with, a customer must in the ordinary course disclose the swap's initial negative market value, irrespective of the complexity of the swap transaction.

On a positive note, the BGH confirmed that the swap transactions were valid agreements, irrespective of whether the municipality had entered into them for speculative or hedging purposes. Several commentators had previously argued that public entities could not enter into any valid swap transactions other than for hedging purposes because these transactions were ultra vires or violated public law.

In relation to the disclosure duties, however, the BGH appears to have confirmed its strict position taken in the leading "Ille" case,2 dating back to 2011 (covered in the May 2011 European Finance Litigation Review). Unless the motivation for an interest rate swap is solely limited to the hedging of risks arising from a corresponding loan agreement, a bank is under a duty to disclose the amount of any initial negative market value of the swap. The BGH measures this market value as the sum of the profit and cost components structured into a swap transaction.

At the heart of the emerging case law is a perceived conflict of interest: the BGH argues that customers do not realise that banks structure a negative initial market value into a swap transaction to make a profit. Instead, according to the BGH, customers assume that banks profit only as a result of interest rate movements.

In contrast to what many experts had predicted, the BGH emphasised that the conflict of interest exists, irrespective of the complexity of the particular swap. Therefore, the obligation to disclose the initial negative market value appears to extend to all swap transactions that do not exclusively have a hedging purpose. As such, the decision apparently puts an end to the hopes that the "Ille" case from 2011 was based on the particular circumstances of that case, namely the complex structure of the so-called CMS spread ladder swap in that case.


1. 22 March 2011, file No XI ZR 33/10.
2. See:

Legal and Regulatory Risk Note