A recent judgment in Germany ups the heat on banks to be upfront with advice on the specifics of derivatives investments. By Roland Hoffmann-Theinert and Wilko Rozman
A decision by the German Federal Supreme Court (BGH) in the Ille Papier case will have considerable consequences for all banks that have offered, or plan to offer, structured financial products in Germany.
In particular, the BGH’s judgment will have a significant impact on investment advice provided in connection with derivatives transactions. All banks offering derivatives and other financial products must review their potential exposure on the basis of products sold in the past and also ensure that compliance with the court’s heightened disclosure requirements is ensured and documented for future sales.
In March the BGH issued a long-awaited decision on the disclosure to customers that banks must make when offering such products. The court awarded damages to a bank’s client for financial prejudice in connection with an interest rate swap agreement.
The client, a mid-sized company, entered into a constant maturity swap (CMS) spread ladder swap with the defendant bank. Under the swap the bank would pay a fixed rate of interest and the client would pay a floating rate calculated with a highly structured formula contingent on the development of the spread between the 10-year and the two-year average swap rate based on Euribor.
The customer stood to profit from a spread exceeding a specific differential. For the customer, the swap transaction implied an unlimited risk of losses, with no quantified worst case. Its opportunity to make profits was limited. The client was liable for approximately €500,000 (£440,000).
Show and tell
The court commented on the specific content of the bank’s investment advisory duties with respect to derivative transactions. In doing so the BGH imposed high standards and pointedly noted that investment disclosure due in “a complexly structured and risky transaction”, such as the CMS spread ladder swap, must be especially rigorous. Note that for German law purposes disclosure implies a duty to bring something to a client’s attention, not merely to provide the information to the client.
The bank may only assume that the transaction matches the client’s risk profile if the bank makes the client aware of the realistic possibility of losses. Bank disclosure of “theoretically unlimited risks of losses”, which is the market standard, is not rigorous enough. Furthermore, the bank must explain to its client all the elements of the formula for the calculation of interest – the formula’s specific consequences must be described in all conceivable developments. These elements could relate to the swap’s floor, cap, leverage, ladder or ‘memory’ effect.
In particular, and crucial for the case, the BGH found that the bank had breached its advisory duties when it failed to explain to the client prior to signing that, from the perspective of the client, the swap contract had a negative market value at the time it was sold. This negative market value is created when a bank prices in a discount reflecting the bank’s risks, costs and profits. The negative market value disclosure required by the BGH exceeds standard or typical disclosure in the sale of derivative products.
Since the losses of the client resulted in proportionate gains for the bank the court found that the bank was significantly conflicted. This conflict was not resolved when the bank passed on to other market participants the opportunities and risks under the swap through hedging transactions. This is because the bank had deliberately structured the swap agreement so the market would value negatively the risk assumed by the client, permitting the bank to sell its position to a third party.
The court emphasised that, in a business relationship existing only between bank and customer, the bank is not obliged to disclose its goal of profiting from the sale of a product. However, the characteristics of the CMS spread ladder swap constitute “special circumstances”. Precisely what these circumstances are remains hotly disputed. They require that the bank explains on an exceptional basis its own interest in profits.
The court’s requirement that negative market value be disclosed could apply to all derivative products that have a negative market value at sale. Options, forwards and swaps could all be affected, along with interest-based derivatives and those pegged to currencies or commodities. While the court focused on exotic over-the-counter derivatives, it left it unclear whether the enhanced disclosure duties also apply to plain vanilla derivatives or transactions concluded for the purpose of hedging risk.
It is unlikely that the BGH will create similar information requirements for all types of derivatives. However, it is likely that customers who bought derivatives in the recent past will assert claims against banks for damages in connection with losses under interest swap agreements and other derivatives. Banks will need to evaluate whether the court’s higher disclosure requirements are met when selling derivative products, in particular those with an unquantifiable risk of loss, complex structures or asymmetric opportunity/risk profiles.
Roland Hoffmann-Theinert is a partner and Wilko Rozman is of counsel at Görg