German Federal Court defines exceptions from disclosure obligations regarding swaps
Federal Court of Justice (BGH), judgment dated 22 March 2016, file No XI ZR 425/14
Exactly five years since its landmark decision on disclosure obligations around swaps, the BGH defined two key exceptions allowing the advising bank to successfully defend liability.
Banks have known since the leading BGH decision dated 22 March 20111 (Ille) 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. The court assumed that the existence of a negative market value reflects a severe conflict of interest for the bank while advising its customers.
Relying on the Ille decision, many companies, individuals and municipalities have lodged claims for damages. Several appeal courts reached inconsistent conclusions on how far-reaching the disclosure obligation is.2 Last April,3 the BGH held that a bank must disclose the initial negative market value irrespective of the complexity of the swap transaction, but also clarified that no such disclosure duty exists if the sole motivation for an interest-rate swap is to hedge risks arising from a corresponding loan agreement. It has been unclear how this exception applies.
The BGH has now answered this question: a "corresponding loan agreement" must be agreed between the same parties as the swap agreement. The swap will only be considered as an instrument to hedge risk if the amount and the term of the swap are equal to, or at least do not exceed, those of the loan agreement.
Under these highly fact-specific circumstances, the advising bank does not need to disclose the initial negative market value to a client.
Another aspect of this decision is helpful for the banks. Based on an earlier decision of the BGH, it was argued that banks not only have to disclose the existence of a negative market value but also the exact amount. The BGH has now found 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. The rationale behind this is causation. The court held that a client's absence of interest in the exact amount of the negative market value reveals that it was not a decisive factor for the conclusion of the agreement.
1. See article "German Federal Court of Justice (BGH) renders opaque judgment in mis-selling case regarding interest rate swaps", Allen & Overy European Finance Litigation Review March 2011.
2. See article "Disclosure obligations and swaps: An analysis of regional variations in Germany", European Finance Litigation Review February 2014: http://www.allenovery.com/publications/en-gb/european-finance-litigation-review/western-europe/Pages/Disclosure-obligations-and-swaps-An-analysis-of-regional-variations-in-Germany.aspx.
3.See article: "Banks must disclose initial negative market value of swaps in two party scenarios": http://www.allenovery.com/publications/en-gb/european-finance-litigation-review/western-europe/Pages/Bank-must-disclose-initial-negative-market-value-of-swaps-in-two-party-scenarios.aspx.