Sell suits

Litigators have had a busy financial crisis. While angry investors look to claw back their capital as markets disintegrate around them, law offices throughout the world have been inundated with every kind of claim imaginable.

"In an environment where someone is standing to lose quite a bit of money, they'll always look for a way out. When times are hard, litigators are generally very busy," says Clive Rough, Hong Kong-based partner at Freshfields Bruckhaus Deringer.

In particular, a range of derivatives products has not performed as originally envisaged, having been hit by enhanced volatility in financial markets. End-users have not been slow to file lawsuits as a result, claiming some dealers are guilty of mis-selling or misrepresenting the risks of these instruments.

In Austria, state-owned OBB-Holding, a Vienna-based railroad company, has written down EUR607 million on a synthetic collateralised debt obligation (CDO) portfolio and is suing its counterparty, Deutsche Bank. Meanwhile, the city of Milan has accused four international banks of mis-selling interest rate swaps and other derivatives it entered into when restructuring EUR1.68 billion of debt (see box). Unfortunately, as the lawsuits are still in the early stages - and in many cases have not been made public - it is difficult to obtain much detail on the trades in question.

However, dealers and many lawyers argue many of the allegations are baseless. They claim documentation and selling processes have been sufficiently polished since a spate of high-profile mis-selling cases in 1994, which included Cincinnati-based consumer goods company Procter & Gamble and Cincinnati card company Gibson Greetings, which filed claims against Bankers Trust.

"Generally, people do play by the rules and accept the documentation works. You occasionally get a few bits of litigation, but the number of disputes compared with the trillions of dollars in derivatives that are out there is infinitesimal," says Rough.

Such conclusions seem to be supported by the way local regulators treated the numerous cases of Brazilian and Mexican companies that had lost out on forex derivatives towards the end of 2008. Many of the complaints were centred on target redemption forwards, which allowed corporates to sell US dollars at more favourable rates than could be achieved using vanilla forwards, but which knock out once a predetermined profit has been reached. However, the notional amount of dollars the corporate must sell increases if the exchange rate moves against it and breaches a certain barrier, with no limit on the losses that can be accumulated. And with the US dollar strengthening rapidly against local currencies in 2008, some companies were hit hard with hundreds of millions of dollars in mark-to-market losses.

Nevertheless, the regulators of both countries opted not to focus on claims of mis-selling, instead enforcing new regulation to make corporates disclose their derivatives positions publicly. In Mexico, the regulator even investigated certain companies for taking speculative positions and trading with multiple counterparties (Risk January 2009, page 91).

Conversely, a series of filings in South Korea involving foreign exchange options have brought the question of suitability back to the fore. The scenario was comparable to Mexico and Brazil: local exporters sustained heavy losses on forex derivatives positions after the US dollar rallied in October 2008.

In Korea, the currency option contract of choice was the knock-in knock-out (Kiko), designed to protect the corporate against won appreciation, but at reduced cost. The transaction involves a combination of knock-in and knock-out barrier options, which give the company the right to sell US dollars at a favourable exchange rate until the won appreciates above a predetermined knock-out barrier. However, if the won falls and breaches another barrier level, the knock-in option kicks in, forcing the company to sell dollars at a worse-than-market rate. Consequently, when the won touched an 11-year low of 1,596 against the dollar on March 2 this year, having started 2008 at 936, myriad small and medium-sized enterprises in South Korea faced mounting losses.

Subsequently, a number of companies filed lawsuits against the banks that sold them the products, based on various legal grounds including fraud, mis-selling and unfair enrichment. Between December and February, the Seoul Central District Court granted four preliminary injunctions to suspend derivatives contracts involving trades conducted with Standard Chartered First Bank Korea, Woori Bank and Citi, while seven other applications were denied.

Ominously for banks, the injunctions allowing corporates to suspend the contracts were based on the principle of equity in the Korean Civil Code and, in particular, the doctrine of changed circumstances - in other words, the contracts were suspended on the basis the companies failed to fully understand the likelihood of the won depreciating to such an extent - as well as adequacy of risk disclosure, product suitability and duty to protect customers. Furthermore, the preliminary injunctions granted against Woori and Citi considered whether the banks had provided ongoing advice after the contract was entered into - a precedent that would go against current dealer practices.

The rulings concerned dealers, not least because they were followed by a deluge of similar filings by corporates. According to the International Swaps and Derivatives Association, there were more than 330 such cases pending in the Seoul Central District Court as of March 10.

"It is alarming when particular jurisdictions are being very protectionist and try to shift all the risk of these products to the banks that originate them. You can't have any cross-border transactions if you don't have legal certainty. If the judgements are reducing the enforceability of these contracts, that is not good for anybody," says one London-based lawyer.

Isda moved fast to urge the court to revise its decisions. In particular, it objected to the use of changed circumstances as a basis for the suspension of the contracts. On April 24, with a new judge in the Seoul Central District Court, a new round of judgements was announced: three preliminary injunctions to suspend the Kiko contracts were granted against Shinhan Bank, Hana Bank, Citi and Korea Exchange Bank, while seven other injunctions were rejected by the court. Crucially, the injunctions based on the doctrine of changed circumstances were not granted. The court also ruled it would "limit the scope of protection of export companies to those that entered into normal foreign currency hedging transactions", according to a translation of the court release obtained by Risk.

However, the rulings did raise fresh concerns for dealers active in the region. First, the summary statement from the court suggested banks may need to review selling practices when dealing with corporates: dealers "engaged in active marketing activities that stimulated the expectation of the exchange rate declining, while concealing the premium payment involved and induced the applicant companies to enter into the Kiko contracts", the court stated.

Second, the rulings suggest dealers will have a heightened responsibility to ensure suitability and disclose risks. According to the judgement, the "expert bank has an obligation to recommend a suitable product to the counterparty company". It also emphasises the dealer's duty to explain the risks of a given transaction so the counterparty can "accurately evaluate the transaction structure and risk involved".

The ruling on suitability concurs with Korea's Financial Investment Services and Capital Markets Act, which came into force in February 2009. Jiwoong Lim, partner at Yulchon in Seoul, a law firm that represented Shinhan Bank and Korea Exchange Bank in preliminary rulings, says the new act classifies normal corporates as non-professional investors. As such, banks would be required to provide detailed disclosure and determine the suitability of a customer.

"These court rulings create a new burden for Korean banks and foreign banks to offer their best hedging products. This may hinder the development of the Korean derivatives market," notes Lim.

Other lawyers agree the rulings on suitability and disclosure of risks signal some dealers need to bolster their current practices. "It may be a problem for banks: they will require additional compliance procedures to deal with those issues," says Simon Firth, London-based partner in the derivatives and structured products group at Linklaters.

The latest judgements mark a significant divergence from laws in other developed markets. The Markets in Financial Instruments Directive (Mifid), enacted by the European Union on November 1, 2007, states that as long as the counterparty has been clearly informed that the investment firm is not required to assess the suitability of the instrument, it will not be afforded the corresponding legal protection.

"As far as the UK is concerned, and as far as most sophisticated jurisdictions are concerned, when you are dealing with a sophisticated investor like a corporate, as long as you make it clear you are not advising them, then you don't have a duty to give advice or ensure the product is suitable. I think it's legitimate for the bank to say to the investor: 'we're not going to mollycoddle you'. The corporate has a responsibility to ensure it has sufficient controls in place," says Firth.

In a typical transaction, banks will include risk warnings within the documentation, explaining the risks the end-user will be exposed to. "When done properly, which generally speaking they are, they do provide adequate risk disclosure to the corporate," adds Firth.

Indeed, all lawyers contacted by Risk agreed most large global banks have robust documentation and procedures to stave off any allegations of mis-selling or misrepresentation from corporates. "From a documentation perspective and from a training perspective, the international banks have extremely good, diligent and robust processes to identify these risks, to make sure the documentation adequately discloses these risks, and that the sales process is conducted properly," says the London-based lawyer.

However, litigators representing end-users complain the documentation - as well as being overly dense and verbose - gives banks too much leeway to absolve themselves of any responsibility for the product they sell.

"Banks are issuing incredibly complicated structures, making a lot of profit, yet the regulators are allowing them to attach disclaimers so powerful they absolve the banks of almost any responsibility to explain the products fairly in practice. You've got to ask whether these disclaimers are actually commercially fair in the first place," says Saul Haydon Rowe, principal at London-based Devon Capital, a firm specialising in derivatives dispute resolution.

Haydon Rowe argues the need for a dramatically simplified but legally binding protocol under which banks and clients can operate. "There should be an onus on banks to provide accurate marks, possibly the upfront profit and loss of a transaction, and that banks get used to taking on advisory roles about the suitability of a transaction," he remarks.

Advisory standards are the principal area of contention. Few seem to suggest banks should provide ongoing advice after the contract has been entered into, but litigators representing end-users believe banks should provide more adequate advice on the suitability of products before the contract is signed.

One ex-Isda board member acknowledges the importance of suitability. "These are above-average products in terms of complexity, so there should be enough disclosure about the risk profiles and returns of these products, as well as suitability tests to see whether they are going to people capable of assessing their risk. It shouldn't heap a huge burden on banks because this should be part of their business: knowing their client," he says.

Banks and certain industry bodies remain opposed to across-the-board suitability tests and disclosure requirements, however. "The more care you have to take of a customer, the more overheads will be, which will put up the costs. There are some market participants for whom that is not necessary and it is perfectly reasonable that such market participants should be able to operate without having to effectively subsidise all those overheads if banks have to perform extra checks," argues Richard Metcalfe, London-based head of policy at Isda.

Nonetheless, other industry bodies believe more could be done with regard to some of the more complex products in the securitisation market. In a May 5 report, the International Organisation of Securities Commissions recommended regulation to "strengthen investor suitability requirements, as well as the definition of sophisticated investor in (the securitisation) market". It is not surprising efforts have been focused on this genre of instruments: Haydon Rowe notes the majority of derivatives disputes at the moment involve the alleged mis-selling or misrepresentation of the risks involved in CDOs or CDOs of asset-backed securities.

There were also rumblings of establishing a new code of best practices for banks at the Isda annual general meeting in Beijing in April. Pierre-Emmanuel Juillard, Isda board member and head of structured finance at Axa Investment Managers, said: "There has to be a code of best practice - if people don't meet the criteria, you shouldn't trade or buy products from them."

End-users remain sceptical about the efficacy of a voluntary code, but the ex-Isda board member insists it should work: "Most of the industry would comply with such a code. If banks ignore it, it would be at their own peril: once you get taken to court, you get bad press as well as reputation risk."

Isda, however, is unwilling to commit itself to formulating such a code in the near future. "This is not an active project at this stage. The range of regulation and legislation is not getting any simpler - that is a challenge, and perhaps one the industry should stand up to. But the current rules do provide a clear and level playing field - they clearly set out an approach to suitability and appropriateness," says Metcalfe.