Litigation is growing in England, as it is in the US, as investors and counterparties seek to recover losses sustained in the credit crunch. Difficult markets produce difficult claims. Issues which are likely to arise include the following:
- Negligent mis-management of portfolios: In these claims, an investment manager’s skills are tested against both the mandate and investment guidelines and, where these provide insufficient comfort to the claimant, against broader standards of negligence and market conduct. The best-known example of such a claim in recent years was the English High Court case of Unilever v Mercury Asset Management. It was argued in the Unilever case that Mercury Asset Management failed to take account of the risk of under-performance of the fund and failed to contain that risk. The case settled in late 2001 before judgment was given, leaving people wanting more in relation to guidance from the courts. Whilst some of these cases have merit, some are in effect complaints about a crystal ball not being sufficiently clear and are dealt with accordingly.
- Mis-management of portfolios and non-disclosure: More than a decade ago, when events led to some investors facing losses on portfolios invested in mortgage-backed securities, allegations were made in the ensuing litigation that portfolio managers did not understand the characteristics of the securities in which they had invested, failed to disclose the risks of the strategy they had adopted, had no means to control the risks to the portfolios they had created and could not protect against the effect of unpredicted events on fund performance. Similar claims are made in the current environment, for example, the recent complaint filed against Bear Stearns by the liquidators of two hedge funds.
- Misrepresentation: Reliance and causation are the issues that usually cause a claimant the most difficulty in claims for misrepresentation. Moreover, there are often problems in differentiating a misrepresentation which relates to fact from a complaint about high-powered – and ultimately inaccurate – fortune-telling. There will be no doubt be careful examination of terms of business in relation to waivers of representations and reliance.
- Disputes about the valuation of assets and portfolios: Valuation can be particularly complex on occasion and can all too easily lead to misrepresentation claims which are likely only to be resolved after lengthy expert evidence. There may also be scope for conflicts of interest claims in valuation disputes.
- One key issue for defendants will be causation: Could it be said that the counterparty is the author of its own misfortune for failing to have adequate controls in place? It is also possible that some losses may have been the result of corners being cut in the frenetic transactional activity, with huge pressure on timing and execution, during the months leading up to the credit crunch. In a general market downturn there are also bound to be issues about whether a particular category of investments is subject to “contagion risk” rather than being inherently defective or inadvisable itself.
- Fraud: Perhaps inevitably when the stakes are so high and there are issues of non-disclosure and misrepresentation, there is also likely to be an increase in fraud claims. The claim by Barclays Bank against Bear Stearns in the US, for example, alleges fraud in relation to the collapse of two hedge funds.
- Arguments over what was bought – or sold – and on what terms: Some lenders are regretting “covenant-lite” deals and there are disputes over construction and whether there is a breach.
- Potential claims against credit rating agencies: They are highly influential in the decision to invest and some issuers and assets have been downgraded dramatically and fast over the past few months. This has widespread knock-on effects including generating events of default where the rating slips low enough.
- MAC clauses: Material adverse change clauses, which have already generated much litigation in the US, may well do so in England before the year is out. The aim of these clauses is to allow parties to renegotiate or withdraw from transactions where, between execution and completion, there is a radical change in circumstances. In the UK the effect of such clauses in a takeover is complicated by the requirements of the Takeovers Code. The transaction needs to be radically different from what was contemplated at the time of execution. This litigation is therefore very fact-intensive, which means necessarily lengthy and costly.
- Prospectus claims: With a number of IPOs in trouble, investors think about these claims. Particularly difficult questions are raised in relation to emerging markets issues, where the market is not mature and there may be real limitations on the due diligence which is possible.
- Claims against insurers who back financial risk: The credit crunch has caused nervousness among insurers. The big questions for them will be whether their clients were candid about their situation and whether their disclosures were accurate when the risks were underwritten. Disputes about whether policy wording responds to the particular circumstances are inevitable.
- Investment advice claims: The decision in the High Court case of JPMorgan Chase Bank v Springwell Navigation Corp, which is imminent, is hoped to provide some further authority on these types of claims.
- Employee litigation: Finally, litigation by employees is also likely to increase, as it does in every downturn.
Significant activity is also occurring in the regulatory arena in England, as follows:
- In response to last year’s run on the UK bank, Northern Rock, changes will be made to the framework for financial stability and depositor protection, giving additional powers to the Financial Services Authority (FSA – the financial services regulator in the UK) and the Bank of England. A new insolvency regime for banks may be introduced and compensation arrangements are to be changed.
- 2008 will see significant integration of, and more strategic roles for, compliance and operational risk management within financial institutions. With the extension of more principles-based regulation in England, firms will have to deal with the proliferation of guidance and the challenge of regulatory creep. The FSA’s drive to improve market cleanliness will continue: its focus on criminal enforcement was evident in its first prosecution for insider dealing, announced in January. The activity of hedge funds and private equity is likely to remain the subject of regulatory attention.
- Regulatory focus on fraud prevention controls and on information security will also be heightened following the discovery of substantial trading losses at French bank, Societe Generale.
- The huge increase in the number of criminal and regulatory investigations brought under the US Foreign Corrupt Practices Act (to which non-US companies and nationals are subject if they cause an act in furtherance of a corrupt payment to take place within the US) make this an area of significant risk in Europe, coupled with the US use of the extradition process. Despite little outward evidence of enforcement activity in the UK so far, there are currently 31 separate ongoing overseas corruption investigations; one prosecution is expected to be launched mid-year.
- Last year a review was undertaken by Professor Paul Davies of the London School of Economics into liability for misstatements to the market. The final report of the Davies Review proposed changes to the existing statutory regime on liability for such misstatements. The UK government’s response, due this quarter, may propose legislative amendments to significantly extend the potential liability of issuers.
- In the retail banking sector 2008 has already brought a FSA fine against a firm for persistently using high pressure sales tactics and misleading information to sell customers shares they did not want or could not afford. Judgment is also awaited in the test case brought by the Office of Fair Trading in relation to the uncertainty over bank penalty charges. Billions of pounds are potentially at stake so the decision could have wide repercussions.
- In the wholesale context, the FSA will be looking to product providers to take on greater responsibility for product design, and to end-consumers. Flowing from the impact of the credit crunch, regulatory focus is turning to the valuation of illiquid and complex instruments and management of risk exposure. The FSA had already pointed to inadequate stress testing and made criticisms of certain business models. The Financial Risk Outlook published last month reinforces these points.
- Global regulatory cooperation will continue to expand, with protocols developing amongst global regulators, particularly the SEC, but also within Europe. Initiatives such as the elimination of reconciliation to US generally accepted accounting principles by certain foreign private issuers using International Financial Reporting Standards have already made substantial progress, and the SEC is actively exploring the possibility of a mutual recognition regime which would permit US investors to access foreign listed securities.
In contrast with the US, the regulatory response to the credit crunch in the UK has to date been more concerned with the effectiveness of the regulatory framework than with the actions of individual participants. To some extent, this is because there has to date been less evidence of direct consumer detriment, and the litigation which has been launched has mainly been in the wholesale sector, and concerned with default related issues. Nevetheless, market practices in the UK raise the same issues around valuation, disclosure, conflicts of interest and risk management which are currently the subject of regulatory litigation and class actions in the US. 2008 is likely to provide many challenges in terms of both litigation and regulation.