Earlier this week, the highest civil appeals court in Germany (the Federal Supreme Court (Bundesgerichtshof)) overturned two prior decisions from lower courts (LG Hanau 9 O 1501/07; OLG Frankfurt 23 U 175/08) and ruled that Deutsche Bank AG ("Deutsche Bank") failed to properly advise Ille Papier Service GmbH ("IPS"), a supplier of paper products, as to the risks of certain interest rate swaps products.
In 2005 IPS entered into an Interest Rate Ladder Swap contract with Deutsche Bank which had been marketed by Deutsche Bank as assisting clients to reduce their interest payments. Under the contract IPS was essentially betting that the spread between long term and short term interest rates would increase over time. IPS paid a floating rate of interest over the term of the contract based on the interest rate spread and the bank paid a fixed interest rate.
Prior to entering into the contract, Deutsche Bank prepared presentation documents which indicated that the spread was to widen over time with long term interest rates rising and short term interest rates falling - making the investment profitable for IPS. Such statements were made despite the fact Deutsche Bank was aware that the contract structured by the bank had a negative starting value of approximately €80,000 – a fact that was not disclosed to IPS.
Following the execution of the contract, the interest rate spread continued to decrease, contrary to the assessment from Deutsche Bank, causing losses to IPS. Eventually, IPS paid €566,850 in January 2007 to terminate the contract.
Advice as to the risks of the transaction
Prior to execution Deutsche Bank had advised IPS that its losses under the contract were "theoretically unlimited", however the Federal Supreme Court held that the customer must be told "clearly and without trivialisation" that the risk of unlimited loss for the customer is not only "theoretical" but could be "real and ruinous". The Court was particularly critical in light of the fact that Deutsche Bank had limited its potential losses under the contract by hedging its risk under the contract and that Deutsche Bank had not disclosed the negative value of the swap at the trade date, thus not disclosing its strong self interest and the corresponding conflict of interest as investment advisor of IPS.
The Court further held that for highly complex financial products the bank must ensure that the customer is advised in all respects about the potential risks of the product and "basically has the same knowledge as the advising bank" as only this can ensure that the customer is able to make an entirely independent decision without reliance upon the bank's advice.
In this case it was not necessary to determine whether Deutsche Bank had complied with these strict requirements as it had already violated its advisory obligations by failing to advise of the contract's negative starting value. It was obliged to do so as the manner in which the contract was structured meant that a conflict of interest arose as IPS' losses under the contract directly mirrored Deutsche Bank's gain. The contract, viewed in isolation, would only be beneficial to Deutsche Bank in the event that its prognosis of the movement in interest rates (as communicated to IPS) was incorrect. The Court held that this led to a "substantial conflict of interest" with its advisory duties. This conflict of interest was not resolved by the fact that Deutsche Bank had immediately hedged its own risk under the contract following completion by entering into a series of back-to-back transactions which meant that in reality the movement in interest rate spreads made no difference to Deutsche Bank.
Implications of the decision
The decision is likely to be of great interest to the German banking sector given that lower courts in Germany have considered a number of similar cases since the beginning of the financial crisis and dozens of municipalities and other businesses across Germany invested in loss making interest rate swaps and similar products during the 2000s. While representatives of IPS view this decision as a precedent for similar cases it is currently too early to fully assess whether this decision will establish a precedent for a multitude of similar claims against banks that sold similar products in Germany. Due to the complexity of the products involved, the process adopted by banks for marketing such products and the level of understanding of the clients, each case has to be viewed individually.
The principles set out in the Federal Supreme Courts press release (as to the requirements for how banks shall market structured products) are only partially new, but not necessarily appropriate for a new dogmatic approach:
- Banks need to investigate the risk appetite of their clients investing in structured products. This also applies to clients with professional qualifications ("suitability of investment").
- For complex structured products the risk disclosure must meet high standards of clarity and transparency. The bank must ensure that a client has the same level of knowledge and information to assess the risk.
- In general, a bank does not have to disclose the fact that it is making a profit. The Court held that in this case, however, the initial negative mark to market was seen as a substantial conflict of interest and needed to be disclosed.
Until the Court's judgment is published in its entirety in the next few weeks, the full implications are unlikely to be clear. It remains, inter alia, unclear to what extent and how a bank needs to disclose an initially negative market value of an interest swap contract. The interesting question as to how a bank is capable of examining the risk tolerance of a client and literally puts the client in a position where it has the same basis of knowledge as the bank selling the product remains to be considered.