It is common for international financial institutions operating in the Middle East to be structured so that clients are introduced and referred by the local entity but are "on-boarded" by booking centres in other countries, such as Switzerland.
Those clients are then deemed to be clients of the foreign entity which deals with advising and selling financial products, so that the local entity's role is only to introduce and refer.
In a recent judgment, the DIFC Courts examined this common model and found that Bank Sarasin (Swiss incorporated) and Bank Sarasin-Alpen (DIFC incorporated and 60% owned by Bank Sarasin) were liable for regulatory breaches and contractual breaches, connected with investments worth US$ 200 million, The relevant breaches were connected with client classification and suitability, as well the Swiss entity carrying out financial services in the DIFC, which it was not authorised to do.
This judgment, handed down by Sir John Chadwick at the DIFC Court of First Instance on 21 August 2014 has awarded damages (which are as yet unquantified) but according to public sources amount to several million US Dollars.
Bank Sarasin- Alpen was structured so that it had a DFSA Category 4 licence. The nature of its licence defined and limited the activities it was properly authorised to carry out, so that whilst it was permitted to arrange investments, it did not have the requisite licence for activities such as dealing in investments, for which a category 2 or 3 licence is required. Bank Sarasin Alpen's primary role was to introduce clients to Bank Sarasin. Bank Sarasin (Swiss Incorporated) was not authorised to conduct financial activity by the DFSA and it was envisaged that that financial activity would take place offshore.
As discussed above, this is a common model for DIFC incorporated international financial institutions.
In the course of 2007 and 2008, on the introduction of Bank Sarasin-Alpen, the Claimants (wealthy Kuwaiti nationals) purchased structured financial products from Bank Sarasin (the "Notes"), such as Capital protected notes on the REIT Bskt VIII. The purchases were partly funded by loans from Bank Sarasin and another bank and the total amount put forward by the Claimants for the Notes was US$ 200 Million.
The Claimants' witness evidence at Trial was that they had stressed that they were looking for capital protection combined with a regular income and were assured that they would not lose any money. In November 2008, Bank Sarasin made a margin call (where a demand is made to an investor to deposit additional money or securities, as the account equity value has decreased). When the Claimants did not meet that call, Bank Sarasin terminated facilities and closed the Notes. This resulted in portfolio losses and left outstanding balances on the loans taken out by two of the Claimants to fund the purchases.
Findings against Sarasin-Alpen
Sir John Chadwick held that there was a contractual breach by Sarasin-Alpen of the duty to carry out services with reasonable skill and care. The Judge accepted that the Claimant were not given sufficient warnings as to the level of risk involved in the investments or an adequate explanation of the nature and effect of the documents signed.
There were regulatory breaches by Sarasin Alpen for conducting investment business with these individuals. Whilst Sarasin-Alpen were able to carry out certain investment services, before doing so, they were required to investigate whether the prospective clients came within the definition of a "Client" as set as in the Conduct of Business ("COB") Rules.
- Firstly, there was a failure in complying with client classification requirements. The judge held that this was an intentional failure, with incomplete documents on file and documents in manuscript intending to mislead readers in assuming that the documents were completed by the prospective clients.
- Secondly, if proper client classification had occurred and proper consideration had been given to the individual's level of financial sophistication and knowledge/ understanding of the types of investments involved, it would have been clear that these individuals did not meet that definition but were instead "Retail Customers". The requirements set out by law and regulations must be met and cannot be contracted out of.
- Thirdly, there was a lack of suitability assessment carried out by Sarasin-Alpen and a breach of COB Rule 6.2.1 (1) to ensure that products are not sold which are unsuitable to an individual's investment objectives. The judge held that there was no evidence that had the Claimants understood the nature of the products sold, they would have invested in the Notes or in a comparable structured financial product.
Findings against Bank Sarasin
Somewhat controversially, the regulatory claim against Bank Sarasin (which is not DFSA regulated) was upheld. It was common ground between the Parties that Bank Sarasin was prohibited from carrying on a financial service in or from the DIFC.
- Sir John Chadwick found that Bank Sarasin was carrying on regulated activity within the DIFC, which included dealing with investments as a principal and advising on financial products and credit. This was in breach of the general prohibition at article 41 (1) of the DIFC Law no 1 of 2004.
- Sir John Chadwick highlighted that in practice Bank Sarasin's account statements were dispatched from the DIFC, confirmation forms were sent out from the DIFC and returned to the DIFC. The Bank Sarasin account opening forms were sent to the Claimants from the DIFC and provided contacts details for DIFC employees.
- Whilst these documents were dispatched and returned to Sarasin-Alpen employees, there was insufficient delineation between the two entities, with some documents on file giving a misleading impression that Sarasin-Alpen (DFSA regulated) was the provider of bank accounts and investment services whereas it was Bank Sarasin that was not DFSA regulated.
An order was made that both Sarasin-Alpen and Bank Sarasin pay compensation to the Claimants in respect of the losses which they sustained. The Order against Bank Sarasin was under Article 65 (2) (b) of the DIFC Law no 1 of 2004 which allows for compensation where the general prohibition was breached. The Order against Sarasin-Alpen was made under Article 94 (2) of the same law for breaches of COB rules connected with suitability and client classification.
The case, of course, turns on its unique facts/evidence and we understand that this decision at the Court of First Instance is due to be appealed. Nonetheless, the judgment certainly evidences a willingness by the DIFC Courts to look beyond formal legal structures and focus on practical realities.
The fact that many DIFC financial institutions operate similar structures may cause some to look again at their operations to make sure they avoid similar problems and ensure that there is clear delineation between the entities. DIFC financial institutions should ensure that they are operating within the terms of their licence paying particular regard to its obligations, as set out in the COB rules. Firms incorporated elsewhere but somehow connected with the DIFC also need to review their activity and approach to clients and transactions in the DIFC.