Global | Publication | October 2014
In this edition of the Banking and finance disputes review, we look back to the aftermath of the financial crisis and forward to the new regulatory landscape that it has generated. What emerges is a theme of accountability: regulators are gradually imposing greater personal responsibility on individuals and institutions in the financial sector; courts are similarly ready to hold institutions responsible for their statements and behaviour, using devices such as tracing and estoppel.
In Contractual interpretation in recent capital markets cases, we survey recent capital markets litigation, including disputes arising out of structured finance and derivatives transactions. In Mis-selling and limitation periods and Valuers’ negligence and limitation we look at recent case law in two active areas and consider the potential expiry of limitation periods for crisis-related claims.
In Civil liability of credit rating agencies in Australia, we review transactions arising out of the financial crisis and also anticipate the emerging regulatory landscape. In the last edition of the Banking and finance disputes review, we examined the new EU regime for liability of credit rating agencies; in this article, we compare it to the imposition of liability on a credit rating agency by the courts in Australia. Support of the courts for unwinding fraud and corruption and supplementing regulatory enforcement is also relevant to our final banking article, Recovering misappropriated money. This explores the ability of the court to deploy concepts arising out of unjust enrichment. Our two case notes both highlight a related area: estoppel. In Briggs v Gleeds, a recent case on execution of deeds (which has turned into a trap for the unwary in executing financial transactions), estoppel is a possible basis for relaxing formal requirements. In Kaupthing Singer & Friedlander v UBS, estoppel allowed recovery of a mistaken payment.
In our regulation and investigations section, we start with an analysis of the FCA’s first Enforcement Annual Performance Account published in July 2014 in FCA enforcement: Is it hurting? Is it working? We then turn to new sources of liability for institutions and individuals. Institutions are the targets for Sanctions warning continues for European banks; the individuals affected by Criminal liability for senior bankers will read that article with close interest.
Finally, we cover the relevance of these developments to insurance in How D&O insurance can evolve to protect senior executives.
In this article, we survey recent litigation in capital markets featuring issues of contractual interpretation, drawing out some of the most interesting current issues and identifying key practice points.
The principles of construction of contracts in English law are now well established. The courts determine the intention of the parties objectively, asking not what their actual subjective intentions were, but rather what a reasonable person would have understood the common intention to be. The court uses the written terms of the contract as the primary source, reads the contract as a whole, takes into account the background facts and, in cases of ambiguity, is entitled to prefer the interpretation most consistent with business common sense.
However, what is of particular interest is how these general principles have been applied in recent capital markets cases.
In 2007, a family hotel business called Greenclose entered into an interest rate collar with the NatWest bank under a 1992 ISDA Master Agreement (the ‘1992 ISDA’). The bank had the right to extend the term of the collar. But, to do so, it had to give notice of the extension before 11 am on December 30, 2011.
The bank made various attempts to give notice on that date. An employee faxed the extension notice to Greenclose but this resulted in a failed transmission. The notice was sent by email but an out of office message was received in response. When the bank tried to telephone, there was no response from Greenclose’s office, it being closed for the Christmas period. Eventually, an employee resorted to leaving a message on the Managing Director’s mobile phone. A dispute ensued as to whether the bank had validly given notice to extend. This turned on the correct interpretation of the notice provisions found in Section 12 of the 1992 ISDA and the Schedule to the 1992 ISDA.
Section 12 of the 1992 ISDA states that:
‘12. Notices:
a.Effectiveness. Any notice … in respect of this Agreement may be given in any manner set forth below (except that a notice or other communication under Section 5 or 6 may not be given by facsimile transmission or electronic messaging system) to the address or number or in accordance with the electronic messaging system details provided (see the Schedule) and will be deemed effective as indicated:
...
iii.if sent by facsimile transmission, on the date that transmission is received by a responsible employee of the recipient in legible form …;
...
v.if sent by electronic messaging system, on the date that electronic message is received …’
The High Court found that the ways in which an effective notice could be given were limited to those permitted by Section 12 as supplemented by the Schedule. In other words, it was a mandatory, not a permissive provision. At first glance, this may seem surprising, given the use of the word ‘may’ in Section 12. But importantly, what drove the Court to this conclusion was reading the contract as a whole – one of the key general principles of contractual interpretation.
So, for example, the Court noted that the ISDA prohibits default and closeout notices being given by fax or electronic messaging system. It then reasoned that to apply a permissive construction to Section 12 would mean that such notices could be given verbally, which would make no sense because it would introduce uncertainty where certainty was paramount.
On the basis that Section 12 is a mandatory provision, the Court further concluded that
This case thus provides a powerful example of the importance of following contractual notice provisions to the letter and a valuable demonstration of how English courts approach the interpretation of major standard form commercial contracts.
In particular, the Court noted that the ISDA Master Agreement is probably the most important standard market agreement in the financial world and that, as far as possible, it should be interpreted in a way that serves the objectives of clarity, certainty and predictability, so that the very large numbers of parties using it should know where they stand. In short, an English court should not be expected to creatively interpret major standard form contracts such as the ISDA Master Agreement.
The Court also noted that, because the ISDA Master Agreement is a standard form, it is permissible to take into account published explanatory notes such as the ISDA User’s Guide. Indeed, it drew support for its mandatory construction from phrases used in the ISDA User’s Guides. The Court also relied upon provisions of the 2002 ISDA Master Agreement (the ‘2002 ISDA’) in coming to the conclusion that the words ‘Electronic Messaging System’ in the 1992 ISDA are not intended to include email. For example, Section 12(a) of the 2002 ISDA provides separately for notices being sent by email and by electronic messaging system. Even though the 2002 ISDA was drafted long after the 1992 ISDA, the Court considered the 2002 ISDA and 2002 User’s Guide to be relevant, saying that it would be wrong to ignore any evidence that sheds light on how ISDA or the market interpreted the 1992 ISDA before the collar was entered into.
In this case, the High Court and Court of Appeal came to diametrically opposed conclusions, providing a powerful demonstration of the unpredictability of some interpretation cases.
The case concerned a collateralised loan obligation (CLO) in which some of the underlying loan obligations had matured early. The key issue in dispute was what should be done with the resulting cash proceeds. The transaction documents provided that they should be reinvested in further loan obligations, if the ratings of the Class A1 Notes (issued as part of the CLO) had not been downgraded below their Initial Ratings. Otherwise the proceeds were to be applied towards redemption of the Notes. The Class A1 Notes had initially been rated AAA; they were then downgraded to AA but were later upgraded back to AAA.
At first instance, the Chancellor of the High Court emphasised that, where contracts contemplate that rights and obligations may pass to persons other than the original contracting parties, such as with tradable financial instruments, certainty and clarity are key and that the Court should be particularly cautious about departing from the ordinary meaning of the words used. Against this background, the conclusion he reached was that the reinvestment criteria could no longer be satisfied, essentially because the ordinary meaning of the clause referred to a past event, not a continuing state of affairs. He drew further support for this conclusion by reference to other provisions in the transaction documents and expressed the view that there was simply insufficient admissible evidence to persuade him that his construction was contrary to the commercial purpose of the provision (which on one view could be argued to be the protection of senior noteholders at times when their notes were no longer rated AAA).
On appeal, the Court of Appeal disagreed that the reinvestment criteria unambiguously referred to a past event. It formed this view both on a grammatical basis and taking into account commercial considerations, which it emphasised were relevant to determining whether or not language is ambiguous. Instead, it considered that another potential interpretation was that the reinvestment criteria referred to something which is continuing (i.e. the language was ambiguous). Having reached this conclusion, the Court of Appeal was then able to determine which of the possible interpretations was most consistent with business common sense, which in its view favoured the continuing state of affairs interpretation. If, at the date on which the proceeds arose, the rating agencies had the highest level of confidence that the senior noteholders would be paid in full and on time (as conveyed by a AAA rating), the Court could not see why reinvestment would be absolutely prohibited due to an event which might have taken place years ago.
This outcome arguably appears to be more consistent with the likely commercial purpose of the provision. It also reflects a theme evident in some other contractual interpretation cases, namely that, at times, the appeal courts can appear more open to commercial purpose-type considerations. However, one of the consequences of this can be a sacrifice of predictability. Gone from the appeal judgment were the Chancellor’s words of caution about departing from the ordinary meaning of the words used.
US Bank v Titan concerned a securitisation transaction and raised the interesting question of what happens when provisions in the transaction documents conflict with the offering circular.
Under one of the transaction documents, what was defined as the ‘Controlling Party’ had the right to require the trustee to terminate the appointment of another party, the ‘Special Servicer’. The dispute arose when the junior noteholder sought to exercise this right, directing the trustee to terminate the appointment. This was opposed by other noteholders and so the trustee sought directions from the court via an expedited Part 8 claim. Like Napier Park, the dispute was effectively between different classes of noteholder.
One of the key questions the court had to determine was ‘who was the Controlling Party?’ The servicing agreement clearly provided that the Controlling Party was the issuer, whereas the offering circular indicated it was the junior noteholder. The court applied the definition contained in the servicing agreement, not the offering circular. It agreed that the offering circular was an important part of the factual matrix, against which the servicing agreement was to be construed, but it pointed out that the offering circular was not itself a contractual document. It also considered that the offering circular’s force as an aid to construction of the servicing agreement was minimised by a disclaimer in it that, in the event of a conflict, the terms of the contractual documents take precedence. The court was mindful of the importance of the offering circular to investors, but indicated that noteholders might have claims in respect of the offering circular instead (presumably under Section 90 of the Financial Services and Markets Act 2000).
As the junior noteholder was not therefore entitled to direct the termination of the Special Servicer’s appointment, in practice the remaining contractual interpretation issues fell away. However, the court nevertheless expressed its view on a further issue of interest. This related to a requirement in the servicing agreement to the effect that any termination of the Special Servicer’s appointment would only take effect if its successor had experience in servicing commercial property mortgages on similar terms and was approved by the issuer and the trustee.
The question for the court was whether, as the trustee submitted, the exercise of the trustee’s discretion here was limited to considering the experience of the proposed successor in servicing mortgages of commercial property or whether it ought also to take into account wider considerations. In view of the language of the provision in question, particularly the use of the word ‘and’, the court considered that it was clear that the clause involved two separate and distinct requirements. The role of the issuer and trustee was not limited to an assessment of the experience of the proposed successor. The court also considered this made good commercial sense, there being every reason why the parties should have intended that there should be a proper check on the suitability of the Special Servicer. Past experience was one factor that might be relevant, but there may be others such as whether it was subject to current financial or regulatory difficulties.
It is therefore clear for trustees and issuers faced with this type of provision that it is no rubber stamping exercise; a qualitative judgment has to be exercised. This may be a cause of disquiet to some trustees, not least because the court felt it inappropriate to provide a list of the issues to consider in all scenarios. The decision is currently the subject of an appeal.
Where a bank is granted a discretion which is required to be exercised ‘reasonably’, a debate sometimes arises as to the standard of reasonableness that applies: is the standard an objective one or, for example, is the bank required only to refrain from acting in a way that no reasonable bank would act (akin to a Wednesbury standard)? The Court of Appeal’s most recent pronouncements on the subject in Barclays v Unicredit suggest that, in practice, this debate may sometimes be somewhat academic.
Unicredit and Barclays entered into certain synthetic securitisation transactions. Unicredit had an optional termination right if a regulatory change occurred, provided that Barclays consented to the early termination. Such consent was to be determined in a commercially reasonable manner.
Two years later a regulatory change occurred and Unicredit sought Barclays’ consent to early termination. The court found that Barclays decided not to consent unless it was paid the balance of five years fees under the transactions, a substantial sum. So had Barclays exercised its discretion in a commercially reasonable manner?
At first instance, the Commercial Court essentially held ‘commercially reasonable’ meant reasonable in an objective sense and that Barclays had complied.
In contrast, the Court of Appeal found it unhelpful to debate whether the standard was objective, subjective or otherwise. Instead it preferred to look simply at the meaning of the particular clause in its particular context. Applying that approach, it considered the test to be whether Barclays demanded a price which was way above what it could reasonably have anticipated would have been a reasonable return from the contract. It also confirmed that Barclays was entitled to take into account its own interests in preference to Unicredit. If anything, the Court of Appeal thought its test accorded more with a Wednesbury standard. In any case, applying the test, it again found that Barclays had acted in a commercially reasonable manner.
The Court of Appeal’s conclusion on the meaning of ‘commercially reasonable’ was reached in a few brief paragraphs. While it noted that the words ‘commercially reasonable’ were used in many commercial contexts, it emphasised that the same interpretation would not necessarily apply elsewhere. Some may see this as a missed opportunity to have general Court of Appeal guidance on the meaning of this commercially significant phrase. However, it can also be seen as an indication that the debate as to whether an objective or Wednesbury standard of reasonableness applies may often be of less significance than might sometimes be assumed.
In any event, the judgment is likely to be welcome news to parties exercising these types of discretion, particularly given the Court of Appeal’s express indication that this is not intended to be a rigorous control and that the determining party can take into account its own commercial interests. Unicredit has lodged an application to appeal to the Supreme Court so the debate may yet continue.
Questions of contractual interpretation continue to provide the source of many disputes involving banks and financial institutions. The financial crisis and subsequent events have led to transaction documentation being tested in ways that may not have originally been envisaged. While the courts continue to apply the general principles outlined above and the creative interpretation of capital markets contracts is certainly not the norm, it is not always easy to predict how they will construe a particular provision.
Unsurprisingly, negligence claims by financial institutions against valuers arising from secured lending transactions tend to follow recessions. Property values slumped in 2008 following the onset of the global financial crisis and this has led to more cases reaching the courts recently. However, in the light of low interest rates and the longer term view adopted by lending institutions, we have not seen quite the number of such cases that we did following the collapse of the property market in the early 1990s and it may well be that there are a large number of such potential claims which have not yet been recognised.
This article looks at some recent decisions in this field and at some litigation currently in progress, including claims by special purpose vehicles involved in structured finance transactions. Since there is a real risk that further crisisrelated claims will become time barred unless they are pursued promptly, thereby closing off this potential route for recovery of losses, we also consider limitation issues.
In order to bring a successful claim against a valuer for overvaluing property securing a loan it is necessary to establish negligence, causation and loss. Fundamentally, this means establishing each of the following
There is then scope for the quantum of the claim to be reduced if the lender was itself negligent in its lending practices (contributory negligence).
In a straightforward property loan it will be the lender who will bring the claim against the valuer for negligent overvaluation of the security, having suffered loss following the borrower’s default and the realisation of the security for less than the outstanding loan. It is far more complicated to identify the correct claimant in respect of structured investment arrangements such as commercial mortgage backed security transactions – ‘CMBS’, where the party who ultimately suffers the loss may not have a direct contractual relationship with the valuer. In addition, these cases raise interesting questions about the interaction between limited recourse and nonpetition clauses and the recoverability of loss: in particular, whether the fact that any reduction in cashflows payable to the special purpose vehicle (SPV) arising from an undervaluation leads to a matching reduction in amounts payable by the SPV to bondholders prevents the SPV from suffering any loss due to an undervaluation.
These issues have arisen in two recent cases where the claimant was the special purpose vehicle (SPV) itself, rather than the ultimate lenders: the syndicate of financial institutions or the bondholders. A further two cases are currently being litigated: Gemini (Eclipse 2006-3) v CBRE & Warwick Street and Windermere X CMBS v Warwick Street.
The case of Capita Alternative Funds Services (Guernsey) Limited and Matrix Securities Limited v Drivers Jonas [2012] EWCA Civ 1417 provides a fairly recent and stark example of a negligent valuation resulting in a £12 million judgment for the purchasers of a factory outlet centre in an Enterprise Zone, arising from the valuer’s lack of expertise in valuing such a specialist asset and the associated tax implications.
Capita was the trustee of a trust set up as an investment vehicle for multiple individual investors and Matrix sponsored the creation of the trust and was responsible for establishing and promoting the investment. However Matrix suffered no loss itself. Accordingly Drivers Jonas sought to argue that, in the absence of an engagement letter recording the scope of its duties, it was only retained by Matrix and owed no duty to advise Capita or the investors. The judge at first instance was not attracted by this technical argument and had no difficulty in finding, in the light of the contents of Drivers Jonas’ own report, that it was retained by Capita to provide valuation and investment advice in relation to the leasehold purchase. This aspect of the decision was not challenged on appeal.
Similar issues as to the identity of the correct claimant arose in the very recent Commercial Court case of Titan Europe 2006-3 plc v Colliers International UK plc (in liquidation) [2014] EWHC 3106 (Comm). Titan was an SPV formed by the lender, Credit Suisse, to act as the issuer of securities in a complex CMBS transaction. Credit Suisse lent approximately €1billion in respect of eighteen separate loans secured on commercial property and that portfolio of loans was subsequently purchased by Titan using subscriptions from the investors who purchased the securities in the debt (the ‘Noteholders’). One of the loans was secured on a large commercial building in Nuremberg in Germany, which had been valued by Colliers. When the tenant of that building became insolvent the borrower was unable to service the loan and the security was sold for very considerably less than the outstanding loan. Titan sued Colliers for the loss it claimed arose from Colliers’ negligent overvaluation of the property.
However Colliers sought to argue that Titan was not the correct party to bring the claim because it had suffered no loss. It had purchased the loan with funds raised by the issue of the securities to the Noteholders on a non-recourse basis. Accordingly Titan essentially acted as an economically neutral conduit between the Noteholders and the debt in which they were investing and it was the Noteholders, not Titan, who would ultimately suffer any loss.
The judge held that, whilst the loss might ultimately rest with the Noteholders, for various technical legal reasons they were not likely to be in a position to bring a claim themselves. Titan could be treated as suffering a loss immediately on purchase of the loan for more than its true value and the fact that it had subsequently securitised that debt on a non-recourse basis was irrelevant as a matter of law as being an arrangement with third parties which should not benefit the valuer (the principle of res inter alios acta). Critically, he further held that Titan was contractually required to apply any damages awarded according to the structure to which the Noteholders subscribed when they made their investments.
Colliers also suggested that, although Credit Suisse may have relied on its valuation when making the loan, Titan had not done so. However the judge concluded that even if Titan had not actually seen the valuation before it purchased the loan it could still be said to have relied upon it if it was aware of its existence and contents.
In both of the cases referred to above the claimant was able to establish by expert evidence that, in preparing the valuation, the valuer had fallen below the standards to be expected of a reasonably competent valuer. For instance, in Titan, the judge concluded that the valuer had failed to give sufficient consideration to the possibility that the tenant of the property might not renew its lease and that the property might be difficult to relet or sell because it had been purpose built for the needs of the current tenant and it was very large and ageing.
However, it is not sufficient simply to be able to demonstrate that a valuer has gone wrong in respect of some (or even all) of its inputs. It is still necessary to show that the valuation figure derived fell outside the reasonable range of values that a competent valuer could have reached, known as the ‘margin for error’. As highlighted by Coulson J in cases such as K/S Lincoln v CBRE Hotels [2010] EWHC 1156 (TCC) and the two related cases he decided subsequently, Blemain Finance Ltd v E.Surv Ltd [2012] EWHC 3654 (TCC) and Webb Solutions Ltd v E. Surv Ltd [2012] EWHC 3653 (TCC), the acceptable margin for error can vary depending on the state of the market and the type of property. For instance, if the market is particularly volatile, or very flat, so that there are not many comparables, the margin will be wider and, whilst standard residential properties should be fairly straight forward to value, commercial development projects are likely to be more challenging. Generally, the margin for error for residential property valuations is +/-5 per cent, whilst for commercial properties it is likely to be between +/-10-15 per cent. Indeed in the Titan case the valuer argued that the margin should be 20 per cent or more given the unique aspects of the property in question, although the judge decided that the acceptable margin should be 15 per cent.
As is well known, in the SAAMCO case, the House of Lords (as it then was) effectively held that losses arising out of the subsequent fall in the property market fell outside the scope of duty of care owed by a valuer to a lender. Accordingly a lender’s loss is capped at the amount of the overvaluation (i.e. the difference between the negligent valuation and the true value of the property as at the date of valuation). Subsequently this analysis of what losses fall within the scope of a professional’s duty of care has been applied in a number of fields.
A recent example is Rubenstein v HSBC Bank plc [2012] EWCA Civ 1184, a successful claim brought by a retail client against a financial adviser in respect of investment advice. Mr Rubenstein wanted an investment that carried no risk of loss to his capital, as in due course he wanted to use the capital to fund the purchase of a new house. HSBC recommended that he invest in the AIG Premier Access Bond (which included the Enhanced Variable Rate Fund). Ultimately, following the unforeseeable collapse of Lehman Brothers and the subsequent run on AIG in September 2008, Mr Rubenstein did suffer the loss of some of his capital and he pursued a claim against HSBC. Although at first instance the judge held that HSBC had advised negligently, he then decided, applying the SAAMCO principles, that Mr Rubenstein’s loss had been unforeseeable and too remote, and had not been caused by HSBC’s negligent recommendation but by the ‘extraordinary and unprecedented financial turmoil which surrounded the collapse of Lehman Brothers’ and that therefore the loss fell outside the scope of HSBC’s duty of care.
However, on appeal, the Court of Appeal rejected this approach. In his leading judgment, Rix LJ held that the loss was not caused by the run on the AIG fund but by the impact of adverse market forces on the underlying assets of the fund, which was foreseeable. Indeed it was precisely this ‘market’ risk (as opposed to the risk of ‘issuer default’) against which the bank was supposed to protect Mr Rubenstein and therefore the loss did not fall outside the scope of the bank’s duty of care.
Accordingly, whilst the SAAMCO cap remains likely to be applicable to the majority of claims against valuers, where the loss flows from a cause from which the lender has expressly sought protection (for instance in the unusual event that the lender has asked the valuer to advise about likely future movements in the property market), then it might be possible to seek to recover losses flowing from a fall in the market.
It is common for valuers to seek to reduce the quantum of claims against them by raising allegations of contributory negligence on the lender’s behalf in approving the loan. The court is likely to reduce any damages awarded by an appropriate percentage if it is satisfied that the lender’s approach fell below that of a reasonably competent lender (such as applying an excessive LTV) and that such negligence contributed to the loss. However in a number of recent cases, such as the cases determined by Coulson J in 2012 referred to above, the courts have emphasised that allegations of contributory negligence must be judged in the light of the facts and against the background of the lending market at that particular time, such as during the over-heated market in 2007 when lending policies were less stringent. This led the judge to find in those cases that, for instance,a relatively high LTV of 85 per cent, errors on the borrower’s application form and self-certification of income did not amount to contributory negligence.
As explained at the start of this article, claims against valuers often arise in the wake of recessions. This is partly because valuers are perhaps more prone to overvalue property in an overheated market or fail to appreciate the impact of a deteriorating economy on property prices and partly because of the increased likelihood of borrower default in difficult financial times. However, as it can take some time for lenders to enforce their security and realise any losses, claims may arise years after the date of the relevant valuation. Accordingly it is necessary to consider at an early stage whether any such claims may be time barred.
Claims against valuers are normally brought in both contract and tort and these causes of action have different limitation periods, which can be crucial. Whilst a claim in contract becomes statute barred within six years from the date of breach (which will normally be the date of the valuation), the claim in tort does not become statute barred until at least six years after the lender has first suffered a loss. In the context of valuers’ negligence claims this has been held to occur when the value of the property, together with the value of the borrower’s covenant, first falls below the amount of the loan (see Nykredit v Edward Erdman Group [1997] UKH 53). Accordingly, whilst on the face of it a claim arising from a valuation carried out in 2007 might appear to be potentially time barred, it is quite possible that, on analysis of when the loss occurred, a claim may still be available.
Indeed, a lender may have an even longer period in which to bring a claim. As discussed in our article on Mis-Selling elsewhere in this edition of Banking and finance disputes review, s14A of the Limitation Act 1980 sets out an extended limitation period of 3 years after that date on which the claimant discovered (or ought reasonably to have become aware) that the property had been over-valued (subject to a fifteen year long stop date). Indeed it was on this basis that the claim against Drivers Jonas referred to above succeeded in respect of a valuation given in 2001.
Banks and financial institutions may well have potential claims against valuers arising out of losses sustained during the global financial crisis. Many of these claims are in danger of becoming time barred. Others raise challenging questions of causation and the scope of the duty of care. Nonetheless, if lenders are sitting on losses arising from secured lending transactions entered into during or shortly before the global financial crisis of 2008/9 it is critical that these are reviewed now to ensure such claims are not lost.
In the previous edition of Banking and finance disputes review, we considered Graiseley Properties Ltd & Ors v Barclays Bank plc [2013] EWHC 67 (Comm), in which the Court of Appeal gave permission for claims based on the fixing of LIBOR to proceed to trial in the context of wider claims relating to the mis-selling of interest rate swaps. Graiseley promised a detailed consideration of issues that would be widely relevant for misselling claims, including fraudulent misrepresentation, attribution of knowledge and rescission. However, in April 2014, Graiseley, together with the much less publicised case of Domingos Da Silva Teixeira v Barclays Bank Plc, also involving allegations relating to LIBOR manipulation, were both settled. This leaves one other mis-selling case, Deutsche Bank AG v Unitech Global Ltd, which is on-going.
Meanwhile, the constant presence of mis-selling and index manipulation in the news suggests that these will continue to be a source of litigation. For instance, in July 2014, the Financial Times reported that investors in the Brandeaux Student Accommodation Fund were planning to sue advisers for mis-selling after plans to float the Fund on the stock exchange collapsed (Lawyers prepare case against advisers over Brandeaux,1/7/14). Similar funds have also seen a collapse in asset values. This follows a ban by the Financial Conduct Authority on the promotion of unregulated collective investment schemes to individual nonsophisticated investors imposed from the beginning of 2014.
With regard to index and benchmark manipulation, regulators have also turned their focus from LIBOR to commodity and foreign currency markets. At present, this has led to a number of regulatory investigations. It is possible that mis-selling cases may follow: although these may face significant hurdles in establishing causation.
Another important driver of mis-selling litigation may be the expiry of the six year limitation period that applies to contractual claims. This may lead to a glut of litigation where claims arise out of events during the financial crisis of 2008.
However, mis-selling claimants might also try to take advantage of the extended limitation period for negligence claims set out in s14A of the Limitation Act 1980, which allows claims within three years of the earliest date when the claimant had ‘the knowledge required for bringing an action for damages in respect of the relevant damage’.
This was the argument successfully employed by the claimants in Kays Hotels Ltd v Barclays Bank Plc [2014] EWHC 1927 (Comm). In 2005, the claimant entered into a loan and an interest rate collar with the bank. The collar lasted ten years and provided that if interest rates remained between 4 and 5.5 per cent, as they did from 2005 to 2007, neither side paid. If interest rates rose above 5.5 per cent, as they did in 2007, the bank would make payments to Kays, whereas if rates fell below 4 per cent, as they did in 2008, Kays would pay the bank. Kays issued a claim in November 2012 alleging that the collar had been mis-sold.
The bank applied to strike out the claim on the basis that the product had been sold more than six years before the claim was issued and was therefore time-barred. Kays accepted that its claims for breach of contract and breach of statutory duty were time barred but in respect of its claim in tort Kays sought to rely on Section 14A Limitation Act 1980.
The trigger for the s14A starting date is not knowledge of the precise details of the alleged negligence or sufficient knowledge to identify conclusively that the defendant’s acts or omissions were the cause of the loss. It is sufficient to have enough knowledge to justify setting about investigating the possibility that the defendant has done something wrong (Haward v Fawcetts [2006] UKHL 9).
With the claim against the bank having been brought in November 2012, Kays argued that it had not had the requisite knowledge to bring an action before November 2009 (thereby bringing it within the extended three year limitation period). Meanwhile, the bank argued that Kays knew or should have known that it had a claim before proceedings were issued since, by that date, it had made payments totalling £36,000 and that the essence of Kays’ case was that it was told that interest rates would rise throughout the life of the product and was given no warning about the risk of payment liabilities.
The court dismissed the bank’s application and held that the test was whether Kays had been alerted to the factual rudiments of its claim, sufficient for it to take advice and put proceedings in train. The determinative moment was when it had reason to begin to investigate. Furthermore, the court viewed the bank’s categorisation of the complaint as being too narrow and considered the claim was not based simply on advice or on interest rates, but was more complex because it dealt with questions of suitability of the collar.
In the circumstances, the mere fact that Kays knew that some interest payments were being made for a period of about a year did not give rise to an unanswerable case that Kays knew or ought to have known sufficient facts to make the requisite investigation for the purposes of Section 14A. Consequently, Kays did have a real prospect of establishing that it could rely on Section 14A and its claim would not be summarily dismissed as bound to fail on limitation grounds.
Kays’ actual or constructive knowledge was fact dependent and required a full consideration of all the circumstances. In particular, this would involve the claimant’s sophistication, what it had been told or not told, what its general state of knowledge was in 2008/2009 and what the more general state of knowledge was at the time, such as the anticipated future trend of interest rates, all of which matters were not appropriate for summary determination.
While this was only an application to strike out rather than a trial, it provides valuable guidance as to the approach the court might take to limitation periods in cases of mis-selling. It appears that, in cases of suitability, as opposed to breach of a particular representation, a greater degree of knowledge will be required to trigger the start of time running under Section 14A.
Kays has one other aspect in common with previous cases such as Graiseley: it was an unsuccessful attempt by the defendant to dispose of the case at a preliminary stage. The hurdle for the claimant in these applications is very low, so it should not be surprising when a case is not struck out or summary judgment is not granted. However, these applications are also trailers for the likely judicial interpretation of key issues in the case, and are therefore much analysed. When cases settle before the main trial, as with Graiseley, they become the only relevant judicial statement. It is a tactical consideration in each particular case whether to apply for summary judgment or to strike out the claim but, where the claim is factually complex, it is unlikely to be susceptible to determination at that stage.
Kays v Barclays illustrates that complex mis-selling cases fall into this category. Questions of suitability, in particular, may be regarded as complex and multi-faceted which may also enable claimants to take advantage of s14A to circumvent the limitation period.
It is an increasingly common feature of litigation that a party seeks to recover misappropriated or lost money or assets.
Of course, mistakes can occur innocently where, in the age of electronic banking, money is simply paid to the wrong account. However, all too often money is diverted as a result of fraudulent activity. In many instances the fraudster cannot be found or no longer has any assets and, in such circumstances, a claimant will have to look elsewhere for a remedy, usually to the ultimate recipient. Banks and financial institutions can often find themselves caught in the middle as claimants seek to identify the recipient and freeze the relevant accounts.
Money and other assets may also be misappropriated as a result of corruption. In that case, or where there is a complex fraud, money may be transferred multiple times and across international boundaries in order to obfuscate its source. This adds another layer of complication to the remedies available.
Although intuitively, it would seem that the innocent party should automatically be entitled to the return of his money from the recipient, the legal mechanisms for such recovery are not always straightforward and can often throw up significant obstacles in practice.
There are two common legal avenues for recovery against the recipient of misappropriated funds: (i) knowing receipt or a similar ground based on a constructive trust analysis; or (ii) unjust enrichment, generally falling within the ambit of a claim for money had and received.
From a claimant’s perspective, the benefit of a constructive trust claim is that it gives rise to proprietary rights, provided that the claimant is able to trace the asset or its proceeds. However, neither cause of action provides certainty of recovery. An unjust enrichment claim is susceptible to defences such as change of position. Similarly, a defendant to a knowing receipt claim who can show he is a bona fide purchaser for value without notice will not be liable.
The recent Court of Appeal decision in Relfo v Varsani [2014] EWCA Civ 360 concerned both tracing and unjust enrichment. Each is considered in more detail below but, more generally, the Court of Appeal’s approach arguably demonstrates a willingness on the part of the Court to assist an innocent party in recovering misappropriated funds.
The Relfo case concerned a claim by a liquidator seeking to recover approximately £500,000 which he claimed had been transferred from the insolvent company to the defendant, albeit indirectly. The allegation was that this had been instigated by a dishonest associate of the defendant who had owned the insolvent company and also separately managed the business affairs of the defendant’s family.
The money was transferred from the insolvent company and this was followed by a series of international transfers to various entities at various times of varying amounts in different currencies culminating in a transfer to the defendant. The liquidator argued that the money in the hands of the defendant could be claimed by it through tracing or unjust unrichment.
Tracing is neither a cause of action nor a remedy. It is merely a process by which a claimant will follow his assets, pursuant to an underlying cause of action, such as knowing receipt.
Tracing has been described as being ‘not a matter of court discretion but of property rights’ (Re Montagu’s Settlement Trust [1987] Ch 287). More recently, Lord Millet in Foskett v McKeown [2001] 1 AC 102, stated:
‘We … speak of tracing one asset into another but that … is inaccurate. The original asset still exists in the hands of the new owner, or it may have become untraceable. The claimant claims the new asset because it was acquired in whole or in part with the original asset. What he traces, therefore, is not the physical asset itself but the value inherent in it … Tracing is thus neither a claim nor a remedy. It is merely the process by which a claimant demonstrates what has happened to his property, identifies its proceeds and the persons who have handled or received them, and justifies his claim that the proceeds can properly be regarded as representing his property.’
Complications arose in Relfo v Varsani because of the following potential obstacles to tracing the money
However, the Court of Appeal held that evidential gaps and possible chronological anomalies did not prevent the liquidator from being able to trace the money in equity, or prevent the court from concluding that the money paid to the defendant was substituted proceeds.
There are a number of important points which can be drawn from the Court of Appeal’s decision
Ultimately, it seems that the court will look at the transaction as a whole to determine whether the monies paid to the defendant amount to substitute proceeds. However, the fact that the Court of Appeal has permitted courts to draw inferences in cases of money laundering and financial crime where there are evidential gaps suggests an approach keen to provide relief in appropriate cases.
To succeed in an unjust enrichment claim, a court will need to be satisfied as to
The Relfo decision concerned the second of these questions and specifically whether a claim can be brought against an indirect recipient. The general position is that a claim can only be brought against the direct recipient of a benefit, albeit various exceptions to this had previously been recognised. The Court of Appeal considered that the exceptions should be regarded as being a matter of general principle, rather than a set of separate and discrete exceptions.
However, no further clarification of the nature or extent of this general principle was provided.
It seems that, in essence, there must be a sufficient link between the transaction whereby the claimant conferred a benefit on the direct recipient and the transaction under which the defendant received the benefit so as to make the defendant’s enrichment unjust. Certainly in Relfo, the Court of Appeal was ultimately unanimous in the overall conclusion that the liquidator was entitled to a restitutionary remedy.
However, given that no general principle was articulated, it is fair to say that, in many instances, it may be difficult to determine whether an indirect beneficiary will be afforded a restitutionary remedy. The best that can be said is that it is likely that the court will look at the economic reality of the matter as a whole to determine whether the defendant has been unjustly enriched at the expense of the claimant.
The Court of Appeal’s decision in Relfo is of general interest as providing a practical illustration of tracing and unjust enrichment claims.
As regards tracing, the case is significant in highlighting that, even though there may be evidential gaps, a court may draw an inference that a claimant’s monies are the source of monies paid to the defendant. However, the greater the gaps or anomalies and the more accounts the money passes through, the harder it will be to trace.
As regards unjust enrichment, the decision provides an important example of a claimant succeeding against an indirect recipient notwithstanding that the Court of Appeal has left open the question of the full extent of any general principle underpinning indirect unjust enrichment claims. It remains to be seen whether and how any such principle is developed in future cases.
From a wider perspective, Relfo is one example of the increasing body of jurisprudence dealing with proprietary remedies in the recovery of assets linked to fraud and corruption. In United States v Abacha [2014], Field J granted a freezing injunction in respect of assets that were linked to corruption. He stated that ‘corruption, like other types of fraud, is a global problem and it and its consequences are only going to be dealt with effectively if there is co-operation and assistance not only between the governments of states but also between the courts of different national jurisdictions.’ In FHR European Ventures LLP v Cedar Capital Partners LLC [2014] UKSC 45, the Supreme Court held that a proprietary claim was available in respect of bribes or secret commissions. All of these cases, but Relfo in particular, demonstrate a vigorous approach from the courts in dealing with assets connected with fraud and corruption.
In the last edition of the Banking and finance disputes review, we described the new civil liability regime for credit rating agencies (CRAs) in the EU. This was introduced by Regulation (EC) No 462/2013, implemented in the UK by the Credit Rating Agencies (Civil Liability) Regulations 2013 (the ‘Regulations’). The Regulations allowed market participants to claim compensation from CRAs even where there was no contractual relationship or other relationship giving rise to a duty of care, although it was limited to intentional or grossly negligent actions by the CRA.
Before this new regime was agreed, in 2012, a first instance decision in Australia imposed on CRAs liability to investors under Australian investor protection legislation. This decision has now been upheld on appeal and, in this article, we analyse the appeal decision and its implications for CRAs, financial institutions and investors in the EU and governed by the Regulations.
The Full Federal Court of Australia, delivering its judgment in the matter of ABN Amro & Ors v Bathurst Regional Council & Ors, dismissed all appeals (save for one cross-appeal in respect of the apportionment of claims) and upheld the judgment of Jagot J (delivered on November 5, 2012).
The court’s judgment confirms the findings of Jagot J that a CRA may be liable to investors for its rating of a financial product, a financial institution may be liable to investors in structuring and marketing a financial product to be sold to those investors, and the reseller of a financial product may also be liable to the investors to whom it on-sells such products.
The decision confirms that entities involved with selling, arranging or rating complex financial products may be liable to investors in circumstances where there has been misleading or deceptive conduct or where negligent misrepresentations are made to investors, even if there is no direct relationship between the entity and the investor.
In 2009, 13 local councils in New South Wales commenced proceedings in the Federal Court of Australia against Local Government Financial Services Pty Limited (LGFS) for losses incurred after the councils purchased a complex structured synthetic investment product (a constant proportion debt obligation known as ‘Rembrandt’) from LGFS, which in turn had purchased Rembrandt from ABN Amro. Prior to LGFS’s purchase of Rembrandt from ABN Amro, the product had been assigned a ‘AAA’ rating by Standard and Poor’s (S&P), which LGFS alleged was essential to its purchase (and subsequent marketing) of Rembrandt. LGFS and the councils consequently brought claims against S&P and ABN Amro.
The judgment of Jagot J resulted in orders for damages to be paid to the councils by LGFS, S&P and ABN Amro in the amount of approximately A$15.8M and by S&P and ABN Amro to LGFS in the amount of approximately A$16M. The insurer of LGFS, American Home Assurance Company (AHAC), was ordered to indemnify LGFS in full in respect of its liability to the councils.
LGFS, S&P ABN Amro and AHAC each appealed the judgment.
The finding by Jagot J that the AAA rating assigned by S&P to the notes issued by Rembrandt (the ‘Notes’) was misleading and deceptive in contravention of ss1041H and 1041E of the Corporations Act 2001 and s12DA of the Australian Securities and Investments Commission Act 2001 was upheld by the court. This was because the rating conveyed a representation that, in S&P’s opinion, the capacity of the Notes to meet all financial obligations was ‘extremely strong’, as well as a representation that S&P had reached this opinion based on reasonable grounds and as the result of an exercise of reasonable care and skill, when neither representation was true and S&P knew that the representations were not true when they were made.
The court also upheld the findings that ABN Amro was ‘knowingly concerned’ in S&P’s misleading and deceptive conduct and that ABN Amro itself engaged in misleading and deceptive conduct towards LGFS and the potential investors, with whom it knew LGFS intended to deal, by reason of its use of the AAA rating and the representations it made itself as to the meaning and reliability of the AAA rating, which it knew to be untrue.
In addition, the court upheld the finding that ABN Amro breached its contract with LGFS under which it was to model and structure the transaction by which LGFS would purchase Notes with a degree of security commensurate with an S&P rating of AAA.
The finding that LGFS engaged in misleading and deceptive conduct towards the councils by reselling the Notes was upheld, as were the findings that the Notes were each a derivative under the Corporations Act (as they were not a debenture) and that LGFS had thus acted in breach of its Australian Financial Services Licence in dealing with the Notes.
The court further upheld Jagot J’s finding that LGFS owed a fiduciary duty to each of the councils and that, in its dealings with them, LGFS breached its fiduciary duty to avoid a conflict of interest in relation to the Notes, or to disclose and obtain informed consent to such conflicts.
In finding that the Notes were not a debenture (and therefore fell within the definition of ‘derivative’ in s761D(1) of the Corporations Act), the court commented that an instrument which provides for the return of the amount deposited at a particular time and in a particular amount not linked to the conduct of the business of the company which issued it, but instead linked to and measured by the performance of a separate index, does not constitute a debt falling within the meaning of ‘debenture’ under the Corporations Act. Further, it is fundamental to the nature of a debenture that it be issued by the company which borrowed the funds and this condition was not satisfied in respect of the Notes.
The court rejected the submissions of the appellants that the councils and LGFS had been contributorily negligent in purchasing the Notes and that their damages should be reduced to reflect this contributory negligence.
The court overruled the finding of Jagot J that the councils’ entitlements to damages against ABN Amro, LGFS and S&P (pursuant to s1041E of the Corporations Act) were apportionable claims, holding instead that damages suffered as a result of a contravention of s1041E are not apportionable and that ABN Amro, LGFS and S&P are consequently jointly and severally liable for the councils’ losses.
The court’s judgment confirms the liability of each of S&P, ABN Amro and LGFS to the councils (and the liability of S&P and ABN AMRO to LGFS) for misleading and deceptive conduct in their respective roles in relation to the investment in this complex structured financial product and for the resulting losses suffered by the investors.
The Australian statutory liability is analogous to the European liability regime. In both cases, although the class of possible claimants is wide, only certain behaviour will found liability: in Australia, ‘misleading or deceptive conduct’; in the EU, actions committed ‘intentionally or with gross negligence’.
Interestingly, the court found that the AAA rating constituted an implied representation that the CRA had reasonable grounds for its opinion and that it had exercised reasonable care and skill in forming it. The court also considered that there would be a tortious duty of care owed by the CRA to investors and that the disclaimers in the pre-sale report and other materials available to investors were not sufficient to negate this. These findings could be relevant to similar claims in other common law jurisdictions.
The increased regulatory scrutiny of financial markets following the global financial crisis has extended to CRAs in Europe, the US and elsewhere. In the EU, it has led to increased regulation of CRAs and the imposition of civil liability on them. This lengthy and complex Australian judgment shows that courts may be prepared to find CRAs liable to wide classes of investors.
Estoppel cannot be used to circumvent the statutory requirements for execution of deeds, where the defect in execution is apparent on the face of the deed.
Briggs v Gleeds is a pensions dispute, but it is relevant to banks and financial institutions because it concerns the formalities for executing deeds, which are, of course, frequently used in finance and capital markets transactions.
There has been an increased focus on the statutory requirements for execution of deeds since the Mercury case (R (on application of Mercury Tax Group Ltd) v HMRC [2008] EWHC 2721 (Admin)), which has increasingly led to a formalistic approach to execution. Briggs v Gleeds reiterates the key practice point: follow the statutory requirements for the execution of deeds to the letter. The court applied the statutory requirements strictly even though the result was to unravel nearly 20 years’ worth of documentation. It held that only certain requirements may be circumvented by estoppel arguments: those where the defect is not one that is ‘apparent’ on the face of the deed. It is difficult to predict how the courts will apply the dividing line between apparent and non-apparent defects in practice.
The case concerned a retirement benefits scheme which had been established in 1974 as a final salary scheme (the ‘Scheme’). It was discovered that 30 deeds of amendment and deeds for the appointment and retirement of trustees had been improperly executed between 1991 and 2008. The partners’ signatures had not been witnessed, contrary to s.1(3) of the Law of Property (Miscellaneous Provisions) Act 1989 (the ‘Act’), which provides:
‘An instrument is validly executed as a deed by an individual if, and only if, (a) it is signed (i) by him in the presence of a witness who attests the signature …’.
The trustees issued a Part 8 claim to determine whether the deeds were effective. If not, the Scheme’s deficit could be increased by £45 million. The claimants argued that, although the deeds were improperly executed, they were effective on one or more of the following grounds.
Estoppel by representation: the scheme administrators had represented that the law was such that the deeds could properly be executed in the manner in which they were executed; that such representations should be attributed to the trustees, since the administrators were acting on the trustees’ instructions; and that, by relying on those representations, an estoppel had arisen precluding the trustees (and members) from challenging the execution of the deeds.
Estoppel by convention: there was an estoppel by convention precluding the members from denying that they had accrued benefits on the basis of the defective deeds.
Extrinsic contracts: the members had contractually bound themselves to accept benefits in accordance with the defective deeds by signing forms agreeing to the terms of the documents.
Newey J. held that estoppel could not be used to circumvent the statutory requirements for execution of a deed on the particular facts of the case. The following points are of note.
An estoppel by representation can be founded on a statement of law and the rule to the contrary did not survive the House of Lords decision in Kleinwort Benson v Lincoln City Council [1992] 2 AC 349. However, it is still necessary to show that the representation is not simply one of opinion (i.e. a statement of opinion as to the law may found an estoppel that prevents the person from denying that was his opinion, but not that it was the law) and to show reasonable reliance.
Estoppel by representation cannot be invoked where the relevant document does not even appear to comply with the Act. There was scope for estoppel where the deed was ‘apparently valid’ (e.g. if the attestation were somehow defective), but not here where the defect was apparent on the face of the document. Moreover, the scheme administrators could not be said to have made representations on behalf of the trustees or members of the Scheme in relation to the execution of the defective deeds.
Estoppel by convention had not arisen because the members merely passively accepted the existence of the defective deeds, rather than actively agreeing to them.
In signing various forms, members were exercising rights they thought they had under the Scheme, not accepting or making any contractual offer to vary the terms of the Scheme (except in respect of one amendment agreed by certain members).
The limitation on estoppel by representation, namely that the defect must not be apparent on the face of the document, appears difficult to delineate in practice and harsh in effect. It is artificial, in the sense that, although the absence of a witness may be apparent, it may not be apparent to a non-lawyer that this invalidates the deed. Reliance may therefore be placed on a document which a court may later find contains an apparent defect.
The practical effect of this judgment is that some statutory requirements of deeds will be applied strictly and some may be circumvented by estoppel arguments, depending on whether the requirement is one that is ‘apparent’ on the face of the deed. However, the application of this principle may be difficult to predict in practice.
Banks and financial institutions should be aware that estoppel is a possible argument where there is later discovered to be a defect in the execution of a deed, but that the boundary of this argument is unclear. Accordingly, they should continue to take a strict approach to compliance with the formal requirements and execution of deeds generally.
Payment to the wrong entity did not discharge a liability under an ISDA Master Agreement but the intended recipient was estopped from claiming payment itself.
UBS and Kaupthing Singer Friedlander (KSF) entered into a foreign exchange trade under the 1992 ISDA Master Agreement. One of the payments to be made under the trade was US$65 million from UBS to KSF. However, UBS mistakenly paid this sum to JP Morgan Chase (JPMC) with instructions to credit it to the account of Kaupthing Bank (KhF), KSF’s parent entity.
KSF and KhF both became aware of the error on the day of payment, but they did not tell UBS. Instead, they made arrangements to transfer the sum from KhF to KSF. UBS sent corrected instructions several days later, but before the sum was moved from KhF to KSF both banks collapsed into administration.
UBS then terminated the Master Agreement and calculated a close out amount that excluded the US$65 million (under the ‘Second Method and Loss’ option in the ISDA Master Agreement). KSF accepted the close out amount. Eventually, the administrators noticed the discrepancy and started proceedings to recover the US$65 million from UBS.
Andrew Smith J held that KSF as the intended recipient was estopped from denying that the payment had been discharged, although the payment by UBS had not in fact been a good discharge of the debt.
With regard to the original payment, Smith J considered that the essential point was whether, in accordance with the ISDA Master Agreement, the payment had been made ‘in freely transferable funds’. This means that they must be credited to the account specified for receiving payment, so that the payee has control over the money following payment. UBS’s payment to KhF did not satisfy this requirement. Although the ISDA Master Agreement specified KSF’s account at JPMC, this did not constitute JPMC as an agent to receive money on behalf of KSF.
Smith J also rejected alternative arguments that KhF received the money as agent and that this was ratified by KSF. There was no act by KhF which could be ratified: receiving the money was not an act done by it. Nor did KSF elect to abandon a claim against UBS when it asked for the money to be transferred from KhF.
Smith J dealt shortly with the argument that acceptance of the close out amount was in satisfaction of all outstanding claims. In accepting the amount, the administrators stated that they were not thereby abandoning other claims. Smith J expressly refused to give a view as to whether satisfaction of all claims would otherwise be an implied term in the ISDA close out arrangements generally
UBS’s final set of arguments were based on estoppel and these were successful. Smith J held that there was an estoppel by convention and, in addition, an estoppel by acquiescence or even by representation which prevented KSF from claiming that the sum had not been discharged. The test that applied to all forms of estoppel was unconscionability. Essentially, if KSF believed that the debt had not been discharged, it had not behaved honestly or responsibly in failing to contact UBS. UBS had acted to its detriment by not making any effort to recover the money from KfH as the wrong recipient. Accordingly, the test of unconscionability was satisfied.
Smith J also rejected an argument that the estoppel should only extend to the amount of the detriment. Although this limit might be appropriate for a restitutionary claim, it did not apply in the current case.
Although the judgment is of interest in dealing with the increasingly common occurrence of an electronic payment going astray, its relevance to construction of the ISDA Master Agreement is limited. Smith J avoided considering whether there was an implied term that acceptance of a close out amount calculated in respect of an ISDA Master Agreement constituted a discharge of all claims outstanding between the parties in respect of those agreements. He also refused to allow a late change to pleadings that would have raised a further argument: that UBS’s determination of ‘Loss’ was unreasonable, or otherwise contrary to the ISDA Master Agreement, because it left the US$65 million out of account.
The only area where he gave general guidance was in determining what constituted a payment under the ISDA Master Agreement: an amount to be paid ‘in freely transferable funds’ must come under the control of the payee.
Smith J’s principled treatment of estoppel emphasises the concept of unconscionability as a common requirement for every flavour of estoppel. However, the ‘pro tanto’ argument: that the estoppel should only apply to the extent that there has been a detriment, was dealt with only briefly in the judgment and may need to be revisited.
Although estoppel saved UBS in the particular circumstances, it is clear from this case that recovering a payment made to the wrong payee in error can be fraught with difficulty and the legal basis for doing so can be obscure, leading to uncertainty.
Following publication of the FCA’s first Enforcement Annual Performance Account in July 2014, this article considers what progress has been made by the new conduct regulator and whether there are indications of what the industry can expect in the future.
Following in the footsteps of the FSA, the FCA published its first Enforcement Annual Performance Account in July 2014 (the EAPA 2014), providing a round-up of enforcement action over its first year and an opportunity for the market to assess (i) what progress has been made in terms of achieving credible deterrence; and (ii) whether it is possible to detect any change of approach or emphasis by the new conduct regulator.
Of course enforcement is a time consuming business and the outcomes we have seen over the last year or so since the advent of the FCA relate to investigations that were commenced by its predecessor. According to the FCA’s statistics, it takes between two and three years for a case to conclude following referral to enforcement, depending on the course that the matter takes and whether early settlement is achieved.
This means that the recent EAPA 2014 has to be judged to an extent by reference to the previous business plans of the FSA. Nevertheless, the approach taken and the focus of the current outcomes may provide an indication of the FCA’s direction of travel and what the industry can expect from its new regulator in the future in relation to the key areas of retail and wholesale conduct, senior management and market abuse.
The FSA signalled some years ago that taking enforcement action after consumer detriment had been suffered was not going to be sufficient to deal with persistent conduct issues in retail financial services and that a new consumer protection strategy was needed involving earlier, more robust supervisory interventions, backed by stronger enforcement with a focus on securing redress.
The FCA is now charged with the implementation of that strategy and, in the context of retail enforcement action, it is clear that agreeing a redress package will be a significant element to any settlement with the FCA. The most significant outcomes mentioned in the EAPA 2014 include the £28 million fine imposed on Lloyds Banking Group in connection with inappropriate incentives and the fines for HomeServe Membership Limited (£30.6 million) and Policy Administration Services Limited (£7.3 million) in relation to low-cost insurance. All these cases involved potentially significant redress for customers. More recently (and too late for the EAPA 2014), the insurer Stonebridge International Insurance Limited was fined £8.4 million but was not required to disgorge profits having committed to a redress programme.
Although fines have been rising and are increasingly based solely on a percentage of the firm’s revenue as a result of conduct occurring after March 2010, the redress factor means that the true cost of enforcement action for firms can be significantly higher than the headline penalty. Not only are firms required to compensate customers, they must also pay the costs associated with implementing a redress programme and any remedial action that is required, such as improved procedures, increased resourcing and training programmes.
In terms of the subject matter of the retail enforcement outcomes, as far as banks are concerned, the FCA has not yet demonstrated any particular focus on a retail sector or product and it may be that we have to wait a little longer for any trends to emerge. Given the recent transition of responsibility from the OFT to the FCA, consumer credit is one area in which we may see enforcement action as firms adjust to a new regime and the FCA looks to deliver messages to the market about the importance of embedding a culture of treating customers fairly.
In the meantime, there is little to be gleaned in relation to current retail enforcement activity from the ‘work in progress’ represented by recent decision notices or warning notice statements. Although the FCA makes the point in the EAPA 2014 that some of the cases that the retail enforcement team has been working on are still ongoing and that a number of decision notices have been published, none of these decision notices relates to significant retail misconduct against a major institution.
In keeping with the retail focus on redress for customers, the EAPA 2014 highlights the FCA’s focus on misconduct which disadvantages clients making reference to cases involving overcharging (State Street UK fined £22.8 million) and failing to pass on profits (Forex Capital Markets Ltd and FXCM Securities Ltd fined £4 million).
Benchmarks have also continued to generate outcomes with fines for ICAP Europe Limited (£14 million) and Rabobank (£105 million) in relation to LIBOR (following in the footsteps of earlier FSA cases). The EAPA 2014 also makes reference to ongoing forex investigations but the basis on which action may be taken is not yet clear and it seems likely that it will be some time before we see any enforcement outcomes emerge or even the publication of warning notice statements or decision notices.
The only other significant systems and controls outcome was the £137.6 million fine imposed on JP Morgan in connection with the London Whale. This has been described by Tracey McDermott as ‘an all too familiar story’ and there is certainly nothing new in regulatory action being taken against a bank following a rogue trading incident.
What we have not seen so far is a plethora of cases arising from cultural and governance issues nor a wide range of significant penalties imposed on firms in relation to the systems and controls governing wholesale relationships to the extent that we might have expected. The FCA has indicated that action will be taken where a firm’s culture places profits over ethics and allows misconduct to flourish but this stance has not yet been matched by enforcement action against firms that have failed to embed the cultural values that champion positive behaviour.
Senior management accountability is an area which has received a great deal of regulatory attention in the wake of the financial crisis and the FCA has made it clear that taking action against firms needs to be backed up by action against the individuals who were responsible for the failures.
Although the difficulty of identifying and penalising individuals within large and complex organisations has been publicly recognised by the regulator, there were signs towards the end of the FSA’s reign that its strategy was making some significant headway. The EAPA 2013 made reference to senior directors of HBOS, Prudential and Mitsui whose conduct gave rise to failures of governance and oversight. These were cases which were the subject of debate within the industry and which threatened to keep senior managers awake at night.
However, the last eighteen months have not seen the FCA building on this with any consistency. For all the speeches and publications making reference to the ‘tone from the top’ and ensuring accountability, the senior management outcomes cited in the EAPA 2014 are more straightforward cases involving lack of integrity issues arising from matters such as misleading clients and the regulator. Arguably the most significant outcome in terms of senior management responsibilities was the £30,000 fine imposed on the former Finance Director of Bradford & Bingley, Mr Willford, which involved issues in relation to dealing with emerging financial information and appropriate follow-up and escalation to the board. Mr Willford’s fine was significantly reduced from the amount originally proposed by the FSA of £150,000 and there is no reference to it in the EAPA 2014.
It is true that the EAPA 2014 senior management cases predate the FCA and that, since January 2014, the FCA has exercised its new power to publish information about warning notices a number of times in relation to individuals, including some directors and managers.
However, the issues arising in these cases (including in relation to client money, UCIS business and condoning the misconduct of others) do not seem likely to significantly enhance the market’s understanding of the expectations of senior management or break new ground in terms of accountability.
We have not seen warning notice statements issued to individuals in connection with some of the more significant enforcement actions against firms to which reference was made in the EAPA 2013 such as the PPI complaints handling cases or misselling of insurance.
The EAPA 2014 only has one conviction for criminal abuse to report. The non-criminal outcomes include the more straightforward cases involving deliberate manipulation (such as Coscia and Swift Trade) rather than the more difficult cases involving the so-called ‘gatekeepers’ of insider information and disclosure.
The outcome in the long-running Hannam case commenced by the FSA was too late for the EAPA 2014 and will no doubt feature next year. In the meantime, the FCA will be keen to demonstrate that it is able to pursue and win more of these complex cases against City professionals as part of its credible deterrence objective.
As well as reflecting on what the EAPA 2014 covers in terms of recent enforcement action, it is also worth noting the omissions such as the total lack of Listing Rules cases as well as the other relatively sparse areas highlighted above.
The EAPA 2014 also reveals that 30.2 per cent of cases (excluding threshold condition cases) closed with no further action being taken. This was up 10 per cent from the previous year. This may be a product of the FCA’s increasing willingness to use other tools such as OIVOPs in order to achieve its objectives. It may also reflect the fact that firms and individuals are engaging more proactively and at an earlier stage with the regulator to address concerns and to attempt to avoid enforcement action. It might also be a sign of a more confident regulator which is willing to bring more cases in the knowledge that not all of these will generate outcomes but that the mere commencement of enforcement action together with a reasonable number of high profile successes may be sufficient to achieve credible deterrence.
The warning notice statements and decision notices being published by the FCA in the course of ongoing enforcement action may be a better indicator of the FCA pipeline and the cases being referred to enforcement.
If that is the case, we will be seeing a significant number of LIBOR-related outcomes against traders and relatively junior managers.
However, the FCA will want to ensure that its EAPA 2015 delivers on its key objectives of holding senior management to account in areas of retail and wholsesale misconduct and further progress in the high profile area of market abuse by industry professionals.
Economic sanctions continue to dominate press headlines, both in respect of increasing regulation and regulatory enforcement. As a result, sanctions compliance is a growing concern for international banks and financial institutions. While the long-arm of US regulators remains an obvious issue for non-US banks, significant growth in EU sanctions in recent years and increased scrutiny of sanctions by the UK’s Financial Conduct Authority (FCA) signals a warning for banks and financial institutions operating in the EU and UK.
The ability of US regulators to prosecute non-US banks for causing breaches of US sanctions has been clearly evidenced in recent years. A long list of non-US banks has been subject to substantial penalties for causing US persons to breach US sanctions. The outcome for a number of non-US banks has also involved reputational damage and stringent on-going compliance obligations.
The most recent and well publicised enforcement action by US regulators resulted in BNP Paribas paying a fine of US$8.9 billion for processing billions of dollars of transactions through the US financial system on behalf of individuals and entities associated with countries subject to US sanctions during the period 2004 to 2012. The press release issued by the US Department of Justice confirmed that this is the first time a global bank has agreed to plead guilty to large-scale violations of US sanctions.
Liability in the majority of cases in recent years is based on what was once common practice at several European banks and is referred to as the ‘cover payment method’ or ‘wire stripping’. This essentially involved non-US financial institutions eliminating payment data before sending instructions to the US where that data would have revealed the involvement of US sanctioned countries and entities. Many of these cases involve the more deliberate and egregious examples of non-compliance with US sanctions. However, far more minor, inadvertent breaches can also lead to an obligation on banks to make mandatory disclosures to its regulators (for example in the UK a sanctions breach triggers a mandatory disclosure obligation to HM Treasury), which in turn could expose a bank to further investigations and enforcement by its regulators.
Enforcement in the EU (which is left to individual Member States) has not been as vigorous as seen in the US, but the sanctions regimes are becoming more aggressive. The majority of the conduct giving rise to the enforcement of US sanctions against non-US banks occurred prior to 2010 and in some cases, as early as 2002. During this period there were no equivalent sanctions in place across the EU. Now more aligned with the US, there has been a marked increase in the use of sanctions by the EU in recent years. By way of example, from 2010 to 2011 the number of relevant EU regulations imposing sanctions trebled from 22 to 69, mainly concerning Iran, Syria and Libya. These more recent sanctions regimes are viewed as having real teeth and have made a significant impact on many of their targets. As a result, the EU sanctions regime is more comprehensive than at any previous time, both in terms of the scope of the regulations imposed and regulatory scrutiny.
The approach of US authorities, with their aggressive pursuit of banks for alleged sanctions violations and layering of other charges (such as money laundering and failure to maintain accurate books and records offences in addition to sanctions violations), gives a sense of how regulatory authorities from EU Member States may, or indeed are, following suit. In the UK, the FCA has stated that it expects banks to establish and maintain systems and controls to counter the risk that firms may be used to further financial crime (including transactions subject to sanctions). In practice, this means that in addition to complying with the relevant sanctions regimes, banks must comply with other legal obligations, including the Money Laundering Regulations 2007 and the Proceeds of Crime Act 2002. In relation to maintaining adequate systems and controls, there are a number of potential areas of exposure for banks including Principle 3 of the FCA’s Principles for Businesses (Management and Control), which places obligations on banks to take reasonable care to organise and control its affairs responsibly and effectively. In addition, Rule 6.1.1R of the FCA’s Senior Management Arrangements, Systems and Controls (SYSC) specifically provides that banks must establish, implement and maintain adequate policies and procedures within the context of the firm potentially being used to further financial crime.
This is not an exhaustive list of a bank’s obligations with respect to sanctions; however, it is intended to highlight that the scope of these obligations is quite separate and is in addition to the underlying obligations pursuant to the EU and UK sanctions regimes. The FSA’s settlement with the Royal Bank of Scotland Group (RBS) in 2010 remains a key example of enforcement which may be brought against banks in the UK. The RBS settlement was not based on underlying sanctions violations but instead arose from deficiencies in the systems and controls of RBS to prevent breaches of UK financial sanctions (for conduct between December 2007 and December 2008) pursuant to the Money Laundering Regulations 2007. In a more recent case, Guaranty Trust Bank (UK) Limited was fined in August 2013 for failing to maintain effective systems and controls for customers based in countries associated with a higher risk of money laundering, bribery or corruption, including accounts held by politically exposed persons. The settlement with Guaranty Trust was pursuant to Principle 3 of the FCA’s Principles for Businesses and 6.1.1R of SYSC.
Compliance with EU sanctions requires further attention due to the fact that implementation is complicated; banks dealing across different Member States must also adhere to sanctions laws implemented at the national level. While EU regulations imposing sanctions will be ‘directly applicable’ in each Member State, licensing, enforcement and penalties for violations are implemented at the national level and additional restrictions may be imposed by individual Member States. For example, the EU sanctions against Russia (i.e. Council Regulation (EU) 269/2014 (as amended)) have been implemented in the UK with additional restrictions, including a ban on exporting military and ‘dual-use’ items which could be used by Russian armed forces against Ukraine. Banks involved in trade finance, for example, must therefore consider local restrictions when dealing across Member States.
The US and the EU now appear to be aligned on the rationale of major sanctions, although additional restrictions on Russia are currently wider in scope in the US. To date, the number of UK criminal prosecutions for sanctions offences (outside the finance sector) has been limited, but predominantly successful. In addition to the risk of criminal prosecutions, the FCA is increasing its focus on compliance with sanctions by banks. The FCA recently released a summary of feedback to its consultation on examples of good and poor practice in ‘Banks’ control of financial crime risks in trade finance’ (including a review of controls around sanctions compliance). The trade finance review followed a previous thematic review by the FSA in 2009, which focussed on ‘Financial services firms’ approach to UK financial sanctions’. These types of reviews suggest that compliance with sanctions is a key focus for the FCA. More investigations and enforcement are likely to follow against the backdrop of more sanctions in the EU, including a broader focus by the FCA on the conduct of senior management at banks who are responsible for maintaining adequate systems and controls.
Addressing sanctions compliance is complex and subject to constantly evolving circumstances. Although immediate measures can be taken to identify existing connections with sanctioned individuals or entities, banks and financial institutions must have systems in place to ensure adequate awareness of pending transactions and to ensure a pro-active and consistent approach to compliance. The US and EU enforcement actions referred to above highlight the need for an effective sanctions compliance programme, together with adequate numbers of sufficiently qualified and experienced personnel to execute the programme and escalate issues appropriately.
Banks and financial institutions must be able to demonstrate to regulators that they are fully aware of the sanctions and embargoes which are in place, and the intricacies within each of the sanctions regimes, and that the company has effective systems and controls to regulate compliance and to report issues to regulators where appropriate.
The obligations imposed on banks and financial institutions in connection with sanctions-related compliance programmes tend to be strict and onerous, requiring global consistency, regular testing, effective training, and proper record keeping and reporting. To assist with these obligations there is industry guidance available (such as the guidance issued by the Joint Money Laundering Steering Group), which banks and financial institutions are encouraged to follow. Notably, published industry guidance may be taken into account by a regulator or a court in assessing a bank’s compliance with sanctions regulations. Departures from good industry practice, and the rationale for doing so, may have to be justified to a regulator or a court.
In circumstances where sanctions regulations do not impose specific policy and procedure requirements, regulators expect banks and financial institutions to implement appropriate systems based on an assessment of risk. They often look for a robust and proportionate response to complying with sanctions requirements.
Banks should therefore ensure that any sanctions-related compliance programme is
The UK Financial Services (Banking Reform) Act 2013 marks a turning point in financial regulation in the United Kingdom. Among many other features, the introduction of criminal liability for senior bank management in the case of bank failure emphasises the notion of personal responsibility for reckless decision-making. This article examines the new offence and makes some practical recommendations on steps financial institutions can take to manage investigations which may lead to prosecution under the new offence.
On December 18, 2013 the UK Financial Services (Banking Reform) Act 2013 (the ‘Act’) received Royal Assent. The Act updates the regulatory regime for banking in the UK. Its many innovations reflect the often competing choices facing the legislators – the desire to prevent another financial crash has to be balanced against the importance of maintaining London’s status as a global financial centre, unfettered by unnecessary constraints. Among the many changes introduced by the law, one of the most significant, in scope and symbolism, is the introduction of a criminal penalty for bankers whose ‘reckless’ decisions are found to have caused a bank’s failure.
The backdrop to the introduction of the new legislation was the widespread belief that the 2008 financial meltdown was caused by negligent failures in bank governance. In response to calls for a complete overhaul of the regulatory regime for banks, two commissions were set up by the UK government between 2010 and 2012: the Independent Commission on Banking and the Parliamentary Commission on Banking Standards (the ‘PCBS’). Both were extremely critical of the regulatory regime in place and recommended a raft of changes to rectify what the PCBS report referred to as ‘profound lapses of banking standards’. One recurring feature of their reports was a criticism of the lack of attribution of individual guilt for the bank failures. In other words, the commissions saw the financial meltdown as having stemmed as much from the failure of individuals to make properly considered decisions as from systemic failures. This recognition echoed calls from regulators for new prosecutorial tools. As far back as 2011, Richard Alderman, the then director of the Serious Fraud Office commented that there was the need to introduce ‘some kind of offence of being involved with recklessly running or being involved in the running of a financial institution’. With that in mind, a central theme of the PCBS’s final report in June 2013 was ‘to make individual responsibility in banking a reality’ and among other things, it stated that that there was ‘a strong case in principle for a new criminal offence of reckless misconduct in the management of a bank’. The report added that such an offence would provide regulators with a tool to prosecute the most egregious of failings, ‘such as where a bank failed with substantial costs to the taxpayer, lasting consequences for the financial system, or serious harm to customers.’
Simply put, the new regime is aimed at deterring senior management from reckless decision making. ‘Senior management’ is defined as a person who carries out a specific function (as per section 37(7) and (8) of the Act) at a UK incorporated bank, investment bank or a building society. The crime of ‘reckless misconduct’ in managing a bank has three constituent elements
Proceedings in respect of this offence may be instituted by the Financial Conduct Authority (the ‘FCA’), the Prudential Regulation Authority (the ‘PRA’), the Secretary of State or the Director of Public Prosecutions. Moreover, under section 38(4), if proceedings are instituted by the FCA or the PRA they must comply with any conditions imposed by the Treasury in this respect. A successful conviction could lead to the individual being imprisoned for up to seven years and/ or fined an unlimited amount.
The implications of a prosecution are therefore very serious for the individuals concerned. However, the drafting of the Act raises questions about the likelihood of a successful conviction since the Act delineates an extremely narrow category of behaviour that is required to be proved. To be found guilty of the offence, the person’s decision must have ‘caused’ the bank’s failure, they must have ‘been aware’ that their action could cause the failure of a bank or any of its group companies and their behaviour must have fallen ‘far below’ reasonably expected standards. How these issues will be interpreted will only become clear at the judicial stage. For example, the government argued during the Parliamentary debates on the bill that ‘causing’ the bank’s failure should be understood as having significantly contributed to the failure. However, this interpretation is unsupported by a plain reading of the Act.
Practically speaking, whilst the financial institution employer of an individual subject to an investigation for this offence would, by definition, have failed, there is likely to be a continuing entity. The management of this entity will need to be alive to the problems posed by an investigation. Separately, it is noteworthy that the offence seeks to cast a wide net by making the management of a financial institution potentially liable for the failure of any of its group companies. Therefore, even if the entity at the top of the corporate tree is alive and flourishing, the collapse of a small subsidiary could still lead to potential exposure.
In examining a potential offence under this section, investigating authorities are likely to require a high degree of access to the financial institution and its records. The interference of an ongoing investigation may prove to be a significant burden for the institution in question. Some of these problems are.
Breadth of the investigation: In the absence of any available guidance on what ‘causing’ a bank’s failure might mean and given that the cause of the failure will not usually be clear, we assume an investigating authority would wish to review almost every senior management decision taken over the relevant period. This could raise difficulties for an institution which does not have proper records of its major decisions and where many decisions may have been taken.
Interference with the continuing institution’s daily functioning: An investigation may be a drain on management time, particularly if the financial institution does not have good record-keeping practices and transparent decision-making processes.
Potential cause of management conflict: By its very nature, the new offence criminalises individuals’ actions by holding them responsible for having caused the bank’s failure. However, decision-making in large institutions is frequently a collaborative process with inputs from various stakeholders. An investigation of this sort would be likely to take place many months or years after the decision itself and may cause conflict and dissension among the continuing management.
As an investigation may be triggered months or years after the allegedly culpable decision was taken it is important that detailed records are kept of the decision making processes followed. Any financial institution which considers its record keeping procedures to be inadequate should consider strengthening them now.
There is a risk that the offence may prompt senior management to take overly cautious and defensive decisions. Banks may have to institute clear processes to ensure that the quality of decision-making is not affected while similarly ensuring that the time taken to make decisions is not unduly lengthened.
There is much criticism of the likely ineffectiveness of this offence and the significant hurdles for the regulators to overcome in successfully prosecuting under this provision. For example, a prosecutor may struggle to prove that a financial institution collapsed because of mis-management as opposed to the cause being one of many other outside forces (e.g. fluctuations in interest rates or exchange rates; inter-bank illiquidity; changes in government policy; or a combination of these factors). However, even if a prosecution may ultimately fail, any financial institution (or its successor) which is investigated for the offence is likely be put under a great strain by the investigation.
On July 9, 2014 The Financial Services (Banking Reform) Act 2013 (Commencement No. 5) Order 2014 was issued, which enables the PRA and FCA to begin consulting on this offence and the other provisions under the Act concerning conduct of persons in financial sector services. The consultation process is unlikely to be completed before the end of this year. The offence is therefore likely to come into force by early 2015.
In the meantime, the presence of this new offence on the statute books should lead cautious financial institutions to re-examine their decision making processes, to ensure they comply with the highest standards of transparency.
The Government clearly hopes that the offence will work alongside the other provisions of the Act and the new Senior Persons Regime to effect a fundamental change in the nature of decision-making in financial institutions (even though some may argue such a change had already occurred). As the government noted in its response to the PCBS report, ‘bank directors must maintain an awareness of their responsibility to safeguard the security and stability of their firm. […] changes to introduce new criminal sanctions for recklessness will further sharpen directors’ focus on their personal responsibilities and duties in respect of the firm.’
In recent years, increasing emphasis has been placed on personal accountability in the financial services sector. Regulators have become increasingly willing to take action against senior executives in their personal capacity as well as against the institutions within which they operate.
A raft of proposed regulatory changes in the UK, which will fundamentally change the way in which individuals operating in the financial services sector are regulated, means that this trend is set to continue. These changes affect a range of individuals in financial institutions, including senior executives who will require as much protection as possible from the potential liabilities they face.
Directors’ and Officers’ liability (D&O) insurance, which indemnifies company directors and officers for certain costs and liabilities which they incur in relation to the performance of their duties, is in the process of evolving to provide additional protection.
‘Too many bankers, especially at the most senior levels, have operated in an environment with insufficient personal responsibility. Top bankers dodged accountability for failings on their watch by claiming ignorance or hiding behind collective decision-making … A more effective sanctions regime against individuals is essential for the restoration of trust in banking.’
Parliamentary Commission on Banking Standards (PCBS)
The recommendations made by the PCBS last year have led to proposals for a more stringent system of accountability for the senior executives of banks. Reform in this area, once it is fully implemented, will have a fundamental impact on the risks faced by those senior executives.
One consequence of the recommendations made by the PCBS is that the FCA and the PRA are now consulting on the introduction of a new senior persons regime for deposit-taking institutions. For those firms, this regime proposes to do away with the significant influence functions which currently exist as part of the Approved Persons Regime, which was heavily criticised by the PCBS. Under the new regime, senior individuals who manage (or take or participate in decisions concerning) an aspect of a bank’s affairs that involves, or might involve, a risk of serious consequences for the bank or for business or other interests in the UK will require prior regulatory approval.
An application for approval as a Senior manager will have to be accompanied by a statement of responsibilities, setting out the aspects of the affairs of the authorised person which it is intended that the senior manager will be responsible for managing in performing the function. The result of this is that the senior manager can no longer ‘hide behind the business’; he or she will be directly and personally accountable for all activity within the relevant part of the business.
If the regulator takes enforcement action against a firm, the onus will be on the relevant senior manager responsible for the area where the contraventions occurred to demonstrate that they took reasonable steps to prevent or stop the breaches. This effective reversal of the burden of proof in regulatory enforcement actions will pose an additional challenge for senior managers.
A new criminal offence of reckless misconduct in the management of a bank is another source of potential exposure for senior executives. While it seems likely that this offence will only be relevant in the most serious of situations, senior executives should be aware that a conviction could lead to an unlimited fine or a prison sentence.
While the above reforms are essentially aimed at banks, insurers should note that there is appetite for a similar regime to be introduced in their industry. The Governor of the Bank of England, Mark Carney, stated in May 2014 that ‘… alongside reforms that Parliament has asked us to make to hold senior bankers to account, we will create a similar regime for senior managers in the insurance industry.’
Increased potential liability for senior executives across a range of industries therefore seems to be an inevitability. D&O insurers will no doubt look to offer appropriately enhanced cover to protect senior executives, as far as possible, against these risks.
Senior executives will need to obtain comfort that, in the event that regulatory enforcement action is brought against them, protection is in place to ensure they do not need to fund their own defence or, as far as possible, to account for any other liabilities which they may incur. D&O insurance has a key role to play in this process.
For example, it will be imperative that D&O policies step in to provide cover where the senior executive is not being indemnified by the financial institution in question. The limits on cover in these circumstances will need to be sufficiently high to cover heavy defence costs and potentially large liability exposures. Senior executives may also look to obtain ring-fenced cover or appropriate excess cover to ensure that the protection available to them is not eroded by claims made by other insured persons in relation to the same or related policies. Demand for cover of this type is likely to grow considerably following the implementation of the proposed new regulatory regime.
The new regulatory climate means that senior executives face the very real prospect of losing their personal assets if they become involved in expensive enforcement action. Many D&O policies are evolving to cover personal expenses in these circumstances, such as mortgage payments, utility bills and even school fees, which could provide vital support to senior executives and their families. However, it is important to bear in mind that neither an indemnity nor insurance will be able to pick up the tab for some matters, such as criminal fines or regulatory penalties.
Triggers for cover under a D&O policy also need to be considered in the context of today’s regulatory climate. The new regulatory regime will require financial institutions and their senior executives to be proactive in identifying and mitigating potential breaches of regulatory obligations. These processes can involve substantial costs, for example, if individuals within a financial institution obtain legal representation to assist them with their role in an internal investigation. Senior executives will look for costs of this type to be covered by their D&O insurance. These costs will, however, be incurred before the traditional trigger of an ‘Investigation’ (usually being a formal step taken against an insured person by a regulator or similar official body) has been commenced. Insureds will therefore look for early triggers for cover and comprehensive cover for the costs incurred in relation to, for example, purely internal investigations in respect of alleged wrongdoing.
The risks and potential liabilities of senior executives have never been greater. However, D&O insurance will need to evolve in response to the forthcoming changes in order to fulfil its crucial role in managing board-level risks within financial institutions.
Elisabeth has joined us recently as a partner in the dispute resolution practice based in London.
She focuses on regulatory investigations in the financial services sector. She has represented clients in matters involving both UK and offshore regulators, including the Financial Conduct Authority (FCA), former Financial Services Authority (FSA), former Investment Management Regulatory Organisation (IMRO), Serious Fraud Office (SFO), Jersey Financial Services Commission (JFSC), Securities and Exchange Commission (SEC), and Commodities Futures Trading Commission (CFTC).
Elisabeth has significant experience in undertaking independent internal investigations on behalf of firms in relation to allegations of insider dealing, market abuse and trader mis-marking in the investment banking and hedge fund sectors. Within the retail industry she has investigated allegations of fraud, sanctions breaches, mis-selling and complaints mishandling. She advises clients at all stages of the investigation and enforcement process from selfreporting requirements, to scoping and conducting internal enquiries, through to representation in any consequent enforcement action. She is a former author of the Decision Procedure and Penalties volume of the Butterworths Financial Regulation Service.
From 2010–2011, Elisabeth spent a year on secondment to a major bank where she managed the global retail internal investigations hub spanning the UK, Western Europe, Africa and India. Most recently she has acted as a Skilled Person for the FCA.
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