Summary Welcome to Debevoise & Plimpton’s H1 2014 Banking Litigation and Financial Services Regulatory Update. In this update, we look at some key banking decisions by the English Court and Privy Council and some recent investigations (and financial penalties imposed) by the Financial Conduct Authority in H1 2014. If there are any issues in this update which you would like to discuss, please do not hesitate to contact us. 1. Banking and financial services litigation A. Interpretation of a contractual obligation to make a determination in a “commercially reasonable manner” In March 2014, the UK Court of Appeal handed down its decision in Barclays Bank Plc v Unicredit Bank AG  EWCA Civ 302. The appeal concerned the construction of a clause requiring a party to make a determination in a “commercially reasonable manner” in deciding whether to consent to optional early termination. The court determined that such a provision was intended to be a “control exercise of some kind”, but that Barclays was entitled to take account of its own interests in preference to the interests of Unicredit in deciding whether to refuse to consent to early termination. The basis of this finding was that, on its proper construction, it was the manner of the determination which had to be commercially reasonable: it did not follow that the outcome had to be commercially reasonable. The case concerned a “synthetic securitisation” and is particularly relevant to financial institutions, but it is broadly relevant to the interpretation of commercial contracts. The case is a useful reminder that, unless exceptional circumstances apply, the courts will give effect to the ordinary meaning of the words of contractual provisions, especially where the parties in question can “look after their own interests and contract on different terms if they wish to do so.” Please CLICK HERE for further details. Authors H1 2014 UK Banking Litigation and Financial Services Regulatory Update All content © 2014 Debevoise & Plimpton LLP. All rights reserved. The articles appearing in this publication provide summary information only and are not intended as legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein. Any discussion of U.S. Federal tax law contained in these articles was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer under U.S. Federal tax law. Lord Goldsmith QC Partner phgoldsmith@ debevoise.com Tony Dymond Partner tdymond@ debevoise.com Kevin Lloyd Partner klloyd@ debevoise.com Ralph Sellar Associate rsellar@ debevoise.com JULY 2014 H1 2014 UK Banking Litigation and Financial Regulatory Update | July 2014 page 2 B. Interpretation of a “waterfall payment” provision of a finance document The case of Landesbank Hessen-Thuringen & Ors v Bayerische Landesbank & Anr [May 2014] EWHC 1404 (Comm) concerned the construction of a “waterfall payment” provision of a finance document in circumstances where the sums received by the lenders were less than the amount the borrower was liable to pay. The case is of interest because it is a further example of the English Commercial Court refusing to accept what the defendant asserted was a “commercially reasonable” interpretation of a contractual provision in circumstances where the words of the disputed clause had clear meaning and effect. The lesson is that the Court will not remedy unfortunate commercial bargains where there is no ambiguity in the meaning of the clause. Please CLICK HERE for further details. C. Privy Council rejects Madoff feeder fund’s attempt to recover redeemed funds from investors In Fairfield Sentry Ltd (In Liquidation) v Migani  UKPC 9 (British Virgin Islands) the Privy Council rejected an appeal which was brought by the liquidators of Fairfield Sentry Ltd. (the “Fund”). The Fund had been the largest “feeder fund” to Bernard L. Madoff Investment Securities LLC (“BLMIS”). The proceedings were brought against a number of financial institutions who redeemed some or all of their shares in the Fund before the Madoff fraud was discovered in December 2008. The purpose of the claim was to recover from the Defendants the amounts paid out to them on redemption, on the footing that they were paid out in the mistaken belief that the assets were as stated by BLMIS, when there were in fact no such assets. The issues in dispute concerned a requirement of the Fund administrator to “certify” the net asset value (“NAV”) of the Fund and the possibility of clawing back redeemed funds from investors in circumstances where it was argued that there had been no certification of the NAV, which had been miscalculated at the time of redemptions. The case is of interest to investors, funds and fund administrators and is of particular significance because similar proceedings have been brought by the liquidators of the Fund in other jurisdictions against other investors in order to recover redemption payments. They include more than 300 actions in the United States (which had been stayed pending the outcome of these proceedings), in which the Fund is claiming more than US$6 billion. Please CLICK HERE for further details. 2. Regulatory breaches and fines One of the FCA’s objectives is to uphold the integrity of the financial markets through its Enforcement and Financial Crime Division. In H1 2014, the FCA concluded various investigations of the activities of regulated firms and imposed fines for regulatory non-compliance. In this section we look at some of the investigations conducted by the FCA and pick out some of the key themes and issues. The investigations we look at include: • Barclays Bank for manipulation of the Gold Fixing Process (Please CLICK HERE for a further details.) • Invesco for misleading investors in relation to their exposure to risk (Please CLICK HERE for further details) • Santander for serious failings in the way it offered financial advice to customers (Please CLICK HERE for further details.) • State Street for concealing commission charged to clients of its Transitions Management business (Please CLICK HERE for further details.) • Standard Bank for failure to comply with the Money Laundering Regulations 2007 (Please CLICK HERE for further details.) Summary continued from page 1 continued on page 3 H1 2014 UK Banking Litigation and Financial Regulatory Update | July 2014 page 3 Key Themes 1. Need for Tailored Systems and Controls (Barclays, State Street) In respect of Barclays’ breach of Principle 8 (conflicts of interest), the FCA concluded that although the bank had general policies that dealt with conflicts of interest, none of these provided sufficient guidance to inform traders or their supervisors about what types of conflicts of interest with customers could exist when they traded in the Gold Fixing and what they should do to mitigate those conflicts. State Street failed to put in place appropriate systems and controls around its transition management business to adequately mitigate the risk that employees would mislead and/or overcharge clients. 2. Exemplary/Deterrent Fines (Barclays, State Street, Standard Bank) Step 4 of the FCA’s five-step framework to determine the appropriate level of penalty to be levied in respect of misconduct allows the FCA to consider an “adjustment for deterrence”. The FCA chose to exercise this discretion in the Final Notices for Barclays and State Street. The FCA can also choose to make an example of an institution. This happened with Standard Bank when the FCA noted that it had previously brought action against a number of firms for AML deficiencies and that it had stressed the importance of compliance with AML requirements. 3. Previous Disciplinary Action (Barclays) Disciplinary record can be taken into account, for example Barclays’ involvement in LIBOR/EURIBOR. 4. Protection of Retail Investors (State Street, Invesco, Santander) In the State Street Final Notice, the FCA noted that the savings and investments of retail investors had been jeopardised. In the Invesco Warning Notice, it was noted that most of its investors are retail investors. These investors rely on Invesco to manage their money in line with their reasonable expectations. Business practices must reflect investors’ interests at all times. Similarly, the enforcement against Santander for failure to provide sufficient information about products and suitable investment recommendations was in respect of certain of its retail services. 5. Early Settlement All parties settled at Stage 1 of the investigation process and thus qualified for a 30% discount. According to DEPP 6.7 in the FCA’s Handbook, Stage 1 is the period from commencement of an investigation until the FCA has (i) a sufficient understanding of the nature and gravity of the breach to make a reasonable assessment of the appropriate penalty and (ii) communicated that assessment to the person concerned and allowed a reasonable opportunity to reach agreement as to the amount of the penalty. Summary continued from page 2 H1 2014 UK Banking Litigation and Financial Regulatory Update | July 2014 page 4 continued on page 5 In March 2014, the UK Court of Appeal handed down its decision in Barclays Bank Plc v Unicredit Bank AG  EWCA Civ 302. The appeal concerned the construction of a clause requiring a party to make a determination in a “commercially reasonable manner” in deciding whether to consent to optional early termination. The case concerned a “synthetic securitisation” and is particularly relevant to financial institutions, but it also has broader application to the interpretation of commercial contracts. The case is a useful reminder that, unless exceptional circumstances apply, the courts will give effect to the ordinary meaning of the words of contractual provisions, especially where the parties in question can “look after their own interests and contract on different terms if they wish to do so”. In this update we pick out some of the key issues. Key Points • It was the “manner” of the determination which must be commercially reasonable; it did not follow that the outcome had to be commercially reasonable. But commercially unreasonable outcomes would cause the manner of the determination to be subjected to greater scrutiny. • A party required to make a determination in a “commercially reasonable manner” is entitled to take account of its own commercial interests in preference to the interests of the counterparty. • A “commercially reasonable” determination is a control on the deciding party. A party will not be acting in a commercially reasonable manner if it makes demands which are way above what it could otherwise reasonably anticipate. • The entire agreement clause did not operate to exclude evidence about the way in which parties exercised contractual rights. The Facts The case concerned a “synthetic securitisation” entered into by Unicredit and Barclays in 2008 whereby Unicredit transferred the credit risk in a pool of assets to Barclays who agreed to guarantee the assets and would make quarterly payments to Unicredit in respect of relevant portfolio losses and in return Unicredit paid quarterly premiums to Barclays. The purpose of the transaction was to enable Unicredit to transfer the credit risk of the portfolio of assets without removing it from its balance sheet. The transfer would, however, enable its capital requirements (under the Basel Accords) to be reduced. The lifetimes of the guarantees were 11 years and 19 years, but an Optional Early Termination clause gave Unicredit the option to terminate if “a Regulatory Change occurs in respect of the Bank, provided that the Bank has obtained the prior consent from the Guarantor, such consent to be determined by the Guarantor in a commercially reasonable manner”. At the outset of the transaction, Barclays understood that it could expect to earn at least five years of premium and fees and accordingly it booked five years’ worth of profit. In 2010, however, Unicredit sought to terminate the guarantees early as a result of a regulatory change which resulted in the bank no longer receiving capital relief by virtue of the guarantees. Unicredit ceased paying premiums and contended that the guarantees ended on the date the notice was given. Barclays maintained that the guarantees had not been terminated and remained in force. First Instance Decision Barclays brought proceedings against Unicredit for the unpaid premiums due to it and the first instance judge found in its favour. The judge held in broad terms that Barclays had withheld its consent to early termination in a commercially reasonable Case 1: “Commercial Reasonableness” in the Context of Determinations Made by Parties to Financial Instruments continued on page 6 Case 1: “Commercial Reasonableness” continued from page 4 manner and that Unicredit’s purported early termination in 2010 was invalid and of no effect. Importantly the judge held that Barclays was entitled to take primary account of its own interests in determining whether to consent to termination. The Appeal Unicredit appealed on three grounds, saying that the judge was wrong: • to hold that Barclays was entitled to give precedence to its own commercial interests and thereby to exclude the interests of Unicredit in refusing to consent to early termination; • to hold that Barclays was entitled to demand a sum equal to the entire discounted present value of the fees that it would have received if the guarantees had continued for five years; and • in failing to give effect to an entire agreement clause. The appeal failed on all the issues. Construction of the Early Termination Clause The Court noted that there was considerable debate on how the clause was to be categorised by reference to the relevant authorities. For example, was the clause analogous to landlord and tenant cases in which there is a covenant against assignment without the consent of the landlord “such consent not to be unreasonably withheld”? The Court considered this debate “not helpful” since the meaning of the clause had to be determined as a matter of construction of this particular contract in its particular context. • Issue 1: was Barclays entitled to prioritise its own commercial interests? It was submitted by Unicredit that the clause required Barclays to have regard to the interests of Unicredit in order that a mutual (or a mutually satisfactory) outcome could be achieved. This was rejected by the Court which noted that it was impossible to see how such a proposition could work in practice as it would require some method of discovering and assessing the counterparty’s interests. Such a requirement was likely to be unsatisfactory and could lead to an unfair result. It was held that Barclays was entitled to take account of its own interest in preference to the interests of Unicredit. The basis of this finding was that, on its proper construction, it was the manner of the determination which had to be commercially reasonable: it did not follow that the outcome had to be commercially reasonable. In other words, Barclays was not required to make a determination which had a commercially satisfactory outcome for Unicredit. • Issue 2: was Barclays’ demand “commercialy reasonable”? The Court noted that the clause was intended to be a “control exercise of some kind”. If, therefore, Barclays had said that it would not consent at any price or if it had said that it wanted 11 years’ (or 19 years’ as the case might be) fees as being the full term of the guarantees, that might well not have been “commercially reasonable”. But that was not the case. Barclays did not refuse consent outright: it was conditional on payment of five years of fees. The Court held that, in light of the relevant background, this was not an unreasonable expectation and the determination had been made in a commercially reasonable manner. It is notable that, in reaching this decision, the Court’s analysis appeared to be more focused on the reasonableness of the outcome of the determination as opposed to the manner in which the determination had been made by Barclays. It might have been expected that the Court’s focus should have been on Barclays’ decision making process: for example, on whether the issue went before the Bank’s credit committee or whether appropriately senior employees made the decision to make consent conditional upon payment of 5 years of fees. However, it is assumed that because the determination was so manifestly commercially reasonable, the Court considered that the manner of Barclays’ determination did not warrant greater scrutiny. Entire Agreement Clause • Issue 3: the effect of the Entire Agreement clause. Unicredit submitted that evidence and argument regarding Barclays’ understanding that the contract would last for 5 years was inconsistent with the entire agreement clause of the guarantees. The Court disagreed that this was the purpose or effect of the entire agreement clause. It was necessary for the Court to construe the entire agreement clause strictly. It was not intended to exclude admissible evidence or argument about the way in which parties considered the exercise of rights given to them by the terms of the contract. H1 2014 UK Banking Litigation and Financial Regulatory Update | July 2014 page 5 H1 2014 UK Banking Litigation and Financial Regulatory Update | July 2014 page 6 Case 1: “Commercial Reasonableness” continued from page 5 Comment The Court of Appeal’s decision will undoubtedly be welcomed by financial institutions, particularly as the Court was unwilling to interfere in a commercial contract where the parties can “look after their own interests and contract on different terms if they wish to do so”. It is apparent that the Court of Appeal had no difficulty in construing the meaning of the words in the Optional Early Termination clause. Given that there was no ambiguity in the meaning of the words, the Court of Appeal did not consider that the use of the term “commercially reasonable” in other contractual contexts (e.g. the 2002 version of the ISDA Master Agreement) made any difference to the question of construction of the term in the present case. The Court noted, however, that it was difficult to express a test for commercial reasonableness for the purpose of this (let alone any other) contract. Notwithstanding that difficulty, the Court tentatively expressed the test as being that the party who has to make the relevant determination will not be acting in a commercially reasonable manner if he demands a price which is substantially above what he can reasonably anticipate would have been a reasonable return from the contract into which he has entered and which it is sought to terminate at an early date. The lesson from this decision is that, whilst a party it is entitled to prefer its own commercial interests in circumstances where it is required to act in a “commercially reasonable manner”, the situation should not be treated as an opportunity to make unrealistic commercial demands in return for giving consent. Case 2: Construction of “Waterfall Payments” Under Gherkin Financing Arrangements continued on page 7 1. Introduction Payment waterfall provisions are commonly found in finance documents such as inter-creditor agreements. Payment waterfalls are a contractual scheme for the flow and priority of distribution of receivable funds between debt holders. The case of Landesbank Hessen-Thuringen & Ors v Bayerische Landesbank & Anr  EWHC 1404 (Comm) concerned the construction of a waterfall payment provision of a finance document in circumstances where the sums received by the lenders were less than the amount the borrower was liable to pay. The case is of interest because it is a further example of the Commercial Court refusing to accept a “commercially reasonable” interpretation of a contractual provision in circumstances where the words of the disputed clause had clear meaning and effect. The lesson is that the Court will not remedy unfortunate commercial bargains when there is no ambiguity in the meaning of the clause. 2. Background The loan facility (the “Facility Agreement”) in dispute related to the financing of the purchase of 30 St Mary Axe, London – a building better known as the “Gherkin”. The Facility Agreement was originally between the Borrower and Bayerische Landesbank (“BLB”) which acted as Arranger, Facility Agent, Security Agent and Lender. The Facility Agreement drew a clear distinction between the various capacities in which BLB was acting, notwithstanding the fact that there were no other finance parties. The Facility Agreement was subsequently syndicated to various banks which became Lenders. The new Lenders (known as the “Sub-Syndicate”) were the claimants in this case. The Facility Agreement required the Borrower to enter into a series of interest rate swaps (“the Hedging Agreements”) to manage interest rate risk during the term of the loan. The Hedging Lender was defined as BLB or any other Lender which became a Hedging Lender. The Borrowers were significantly “out of the money” under the Hedging Agreements (due to the significant fall in interest rates since the date of the Hedging Agreements) to the extent that, if early termination were to occur, the Borrowers would be liable to pay the Hedging Lender some £138 million as break gains. During the course of 2013 the Borrower encountered financial difficulty (and it has since entered administration) and various restructuring and enforcement options were being considered H1 2014 UK Banking Litigation and Financial Regulatory Update | July 2014 page 7 Case 2: Construction of “Waterfall Payments” Under Gherkin Financing Arrangements continued from page 6 continued on page 8 by the Lenders, which might involve early termination of the Hedging Agreements. In that context, a dispute arose concerning the manner in which BLB as Facility Agent would be required to distribute amongst the various Finance Parties (defined as the Arranger, each Agent, each Lender and the Hedging Lender) sums received by the Borrowers under the Hedging Agreements in circumstances where it was likely that the sums received would be less than the amount the Borrowers were liable to pay. Accordingly, a claim was brought under the CPR Part 8 process. 3. The waterfall provision The dispute concerned the construction of clause 9.7 of the Facility Agreement which governed the distribution of monies between the various finance parties where the amount received was less than the amount due: “Application of Moneys If any amount paid or recovered in relation to the liabilities of an Obligor under any Finance Document is less than the amount then due, the Facility Agent shall apply that amount against amounts outstanding under the Finance Documents in the following order: (a) first, to any unpaid fees and reimbursement of unpaid expenses or costs (including break costs and hedging break costs) of the Facility Agent; (b) second, to any unpaid fees and reimbursement of unpaid expenses of the Lenders; (c) third, to unpaid interest; (d) fourth, to unpaid principal; and (e) fifth, to other amounts due under the Finance Documents. In each case (other than (a)), pro rata to the outstanding amounts owing to the relevant Finance Parties under the Finance Documents taking into account any applications under this clause 9.7. Any such application by the Facility Agent will override any appropriation made by an Obligor.” The dispute concerned the construction of the underlined words. 4. The dispute It was BLB’s case that because it was the Hedging Lender and thus (unlike the other Lenders) had a risk exposure under the Hedging Agreements, it was commercially sensible and reasonable that any sums paid by the Borrowers upon which there was a shortfall should be paid to BLB as Hedging Lender, in priority to the other Lenders. This proposition by BLB was based on the following arguments: • The reference to the Facility Agent in clause 9.7(a) was shorthand for BLB generally (including in its capacity as Hedging Lender) and not limited to BLB acting in its capacity as Facility Agent. This was because BLB as Facility Agent was only an agent and hence did not enter into any hedging arrangements or other arrangements in that capacity, so it would not incur break costs or hedging break costs. On that basis, if clause 9.7(a) were limited to the unpaid fees and expenses and costs of BLB as Facility Agent, the words in brackets in that provision were meaningless. • If clause 9.7(a) was confined to the fees and costs of the Facility Agent, then if the Obligors made a payment upon early termination of the Hedging Agreements which was less than was due, that payment would not inure to the benefit of BLB but would have to be pro-rated with the other Lenders, notwithstanding that it was BLB which had borne the commercial risk of the Hedging Agreements and the market hedging arrangements it had put in place and notwithstanding that the payment made by the Obligors was made under the Hedging Agreements. 5. Judgment The judge did not accept BLB’s arguments, which foundered on the rock of the reference to Facility Agent in clause 9.7(a). It was clear from the careful way in which the Facility Agreement distinguished between the different capacities in which BLB was acting, that when the phrase Facility Agent was used, it meant BLB in its capacity as Facility Agent only, and it was not shorthand for BLB acting in any other capacity. This distinction between the roles was fatal to BLB’s argument. We pick out some of the reasons given by the judge in support of his decision: • A construction of clause 9.7(a) which interpreted Facility Agent as encompassing Hedging Lender as well would be unworkable and nonsensical. This was because the Facility Agreement contemplated that another Lender other than BLB might become Hedging Lender. It was also contemplated by the Facility Agreement that the other Lenders could terminate the agency of BLB and appoint another bank as Facility Agent. In that event , a construction of clause 9.7(a) which interpreted H1 2014 UK Banking Litigation and Financial Regulatory Update | July 2014 page 8 Case 2: Construction of “Waterfall Payments” Under Gherkin Financing Arrangements continued from page 7 continued on page 9 Facility Agent as encompassing BLB as Hedging Lender was obviously unsustainable. BLB’s argument failed to grapple with the fact that, once Facility Agent in clause 9.7(a) was accepted to mean more than BLB in its capacity of Facility Agent, then there was no basis for limiting it to being also a reference to BLB as Hedging Lender. Rather BLB’s construction would mean that the reference to Facility Agent would be to BLB in all its other capacities, including as Lender. The effect of such a construction would be that clause 9.7(a) gave BLB priority over the other Lenders as regards its fees and expenses as a Lender, which was flatly inconsistent with clause 9.7(b) and the penultimate sentence of the clause, which clearly provide that the fees and expenses of all the Lenders including BLB would be pro rated and that none of the Lenders would receive priority. • The argument that the Facility Agent would never enter into any hedging or other arrangement which might involve break costs or hedging break costs, because it was only acting as an agent, was misconceived. It might very well enter such an arrangement acting as agent for the other Lenders but in circumstances where it assumed obligations as the contractual counterparty to the agreement. However, even if that analysis were wrong and the words in parenthesis had no real meaning because there never could be a situation where the Facility Agent incurred hedging break costs, that would not be a reason for giving the phrase Facility Agent an extended meaning it simply would not bear on the correct construction of the Facility Agreement as a whole. • It followed that this was not a case where a clause was rendered meaningless by a literal interpretation, and there was no need for the court to strain to give effect to the clause in question. Clause 9.7(a) still had a clear meaning and effect, giving priority to the fees, costs and expenses incurred by BLB in its capacity of Facility Agent, even if on the correct construction of the clause, it would not get priority in respect of break costs or hedging break costs because it only incurred those in its capacity as Hedging Lender. To interpret Facility Agent as shorthand for BLB in whatever capacity it was acting, in order to give some meaning and effect to the words in parenthesis would be allowing the tail in the parenthesis to wag the dog of the clause as a whole. This, the judge ruled, was never a permissible approach to construction. In a judgment delivered by Lord Sumption, the Privy Council rejected an appeal sent up from the Court of Appeal of the British Virgin Islands which was brought by the liquidators of Fairfield Sentry Ltd. (the “Fund”). The Fund had been the largest “feeder fund” to Bernard L. Madoff Investment Securities LLC. The proceedings were brought against a number of financial institutions who redeemed some or all of their shares in the Fund before the Madoff fraud was discovered in December 2008. The purpose of the proceedings was to recover from the Defendants the amounts paid out to them on redemption, on the footing that they were paid out in the mistaken belief that the assets were as stated by BLMIS, when there were in fact no such assets. The case is of interest to investors, funds and fund administrators and is of particular significance because similar proceedings have been brought by the Liquidators in other jurisdictions against other investors in order to recover redemption payments. They include more than 300 actions in the United States (which had been stayed pending the outcome of these proceedings), in which the Fund is claiming more than US$6 billion. Key Points On the facts of this case: • The requirement that the NAV be certified did not afford the Fund’s directors discretion to issue a revised “certified” NAV at some undefined time after the transaction. Case 3: Privy Council Rejects Madoff Feeder Fund’s Attempt to Recover Redeemed Funds from Investors H1 2014 UK Banking Litigation and Financial Regulatory Update | July 2014 page 9 continued on page 10 Case 3: Privy Council rejects Madoff feeder fund’s attempt to recover redeemed funds continued from page 8 • It was essential to the proper administration of the Fund that the NAV used to calculate the subscription and / or the redemption price of investments was definitive and binding on the parties at the time of the transaction even if the correct procedure was not followed. • The liquidators could not claw back redeemed funds if it was subsequently discovered that the NAV was in fact much less than was stated at the time of the relevant redemptions. • Unless otherwise specified, the “certification” of the NAV does not require any special formal requirements outside the ordinary meaning of the word. Documents sent by (or on behalf of) a fund which advise investors of the “final” NAV can constitute a certified NAV. In this update we discuss some of the key issues: The Issues The Privy Council considered two principal issues: 1. The first issue concerned the question of whether certain transaction documents issued to investors recording the NAV per share or the redemption price upon redemption were binding on the Fund under its Articles. 2. The second issue was whether the Defendants had a defence on the ground that by surrendering their shares they gave good consideration for the money that they received on redemption. What was the fund obliged to pay upon redemption? The Privy Council noted that it was established law that a payee of money cannot be said to have been unjustly enriched if he was entitled to receive the sum paid to him under a valid contract. It followed that the Fund’s claim to recover the redemption payments depended on whether it was bound by the redemption terms to make the payments which it did make. That question depended on whether the effect of those terms was that the Fund was obliged upon a redemption request to pay either: 1. the true NAV per share, ascertained in the light of information which subsequently became available about Madoff’s frauds, or 2. the NAV per share which was determined by the Fund’s directors at the time of redemption. The starting point to answering this question was the scheme of the Fund’s Articles of Association. It was clear from the terms of the relevant provisions that the Subscription Price (for buying investors) and the Redemption Price (for selling investors) depended on the determination of the NAV per share. It was therefore apparent that the whole scheme of subscriptions and redemptions relied on the price being definitively ascertained on the relevant dealing day. It was the Liquidators’ case that the determination of the NAV was not definitive unless a certificate was issued pursuant to the terms of the Fund’s Articles. The Privy Council found this contention impossible to accept as it would mean that the price would be indefinite until such time that a certificate was issued. This would expose redeeming investors to an open-ended liability to repay part of the price received if it subsequently appeared that the assets were worth less than was thought at the time. Corresponding problems existed in relation to subscribing investors and it would be impossible to properly administer a fund under such a regime. In rejecting the Liquidators’ argument, the Privy Council noted that the Articles “clearly envisaged” that the Subscription Price and the Redemption Price were to be definitively ascertained at the time of the relevant subscription or redemption and, therefore, the NAV per share (on which those prices were based) must be the one determined by the Directors at the time – whether or not the determination was correctly carried out in accordance with the Articles. Further, the Privy Council considered that the certification provision of the Articles must be read as referring to the ordinary transaction documents recording the NAV per share or the Subscription or Redemption Price which would necessarily be generated and communicated to the investor at the time, and not to some special document issued at the discretion of the Fund’s directors. The certificate issue The Privy Council went on to consider whether the determinations of NAV provided to investors upon redemption did in fact constitute a “certificate” for the purposes of the Articles. The certificate issue comprised two sub-issues which were: (i) was the certification of the NAV at the discretion of the Fund; and (ii) were the transaction documents communicated to investors in fact “certificates”. H1 2014 UK Banking Litigation and Financial Regulatory Update | July 2014 page 10 Case 3: Privy Council rejects Madoff feeder fund’s attempt to recover redeemed funds continued from page 9 The relevant article stated: “ Any certificate as to the Net Asset Value per Share or as to the Subscription Price or Redemption Price therefore given in good faith by or on behalf of the Directors shall be binding on all parties” The Liquidators argued that there was nothing in the Articles which obliged the Fund to issue a certificate and therefore the opening words should be read “A certificate, if any”. It was submitted that this showed that there would not necessarily be a certificate in every case. This argument was again rejected as it was impossible to discern what purpose such a discretion could rationally be thought to serve. As had already been decided, the sole object of certification was to produce finality. There was no rational ground for regarding finality as desirable in some cases but not in others, according to the discretionary decision of the Fund. Such a discretion, if it existed, could only operate capriciously and, therefore, was unlikely to have been intended by the draftsman. Turning to the question of whether the transaction documents were in fact certificates, the Privy Council first decided that, a certificate means (i) a statement in writing, (ii) issued by an authoritative source, which (iii) is communicated by whatever method to a recipient or class of recipients intended to rely on it, and (iv) conveys information, (v) in a form or context which shows that it is intended to be definitive. Importantly, unless the legal context required it, there was no reason to think that certificates must satisfy any other formal requirements. Accordingly, the critical question for the Privy Council to answer were whether the transaction documents were issued by an authoritive source and in a form which showed they were intended to be definitive. The authoritive character of the documents was dealt with shortly. They had been issued by the fund administrator under authority conferred upon it by the Administration Agreement and, since the certification of the NAV was not discretionary, it was not necessary to show that the administrator had specific authority to issue certificates. As to whether the documents were intended to be definitive, the context in which they were issued demonstrated that they were. The Privy Council had already decided that it was essential to the prescribed redemption procedure that the NAV was ascertained definitively at the time of the transaction. In that context, any unqualified documentary statement of the NAV must be intended to be definitive. The articles could not have operated in a different fashion. This conclusion was borne out by the language of the documents which described the NAV as the “final” figure. Comment The case was not finely balanced and Lord Sumption was able to dispatch with the issues in a relatively brief judgment of just over 11 pages. The Fund’s case, which effectively afforded the Fund’s directors discretion to set the NAV in an undefined time period after the transaction, would have created unworkable uncertainty for the Fund’s investors. Lord Sumption noted that such a scheme could only be used capaciously. In making that comment, the judge undoubtedly had one eye on the fact that such abuse was more likely to occur in a fund in financial difficulty. The Fund was held to be bound by the redemption terms to make the payments which it did make to redeeming investors and it was not possible recover the redeemed payments. The loss was therefore borne by those who were still investors of the Fund at the date of collapse. This decision will obviously be welcomed by investors who have redeemed their investments in funds which subsequently collapse. Given the fundamental requirement for subscription and redemption prices to be certain and final at the date of the relevant transaction, draftsmen of fund documentation should consider what value any purported formalities (such as certification) add to the transaction process. If certification is to be required, draftsmen should be mindful of the Privy Council’s finding that certification has no special formal requirements outside the ordinary meaning of the word. Therefore, if a particular certification process is envisaged, thought should be given as to how this process is to be defined and administered, and should be documented accordingly. Equally, funds (and fund administrators) should consider whether the documentation that is sent to investors is intended to be definitive and therefore binding. Any pricing documentation which is not final should clearly be marked “indicative” or “subject to certification” etc. H1 2014 UK Banking Litigation and Financial Regulatory Update | July 2014 page 11 continued on page 12 1. Barclays In May 2014, the Financial Conduct Authority (the “FCA”) published a Final Notice imposing a financial penalty of £26,033,500 on Barclays Bank PLC (“Barclays”) for its conduct in the London Gold Fixing Process (the “Gold Fixing”). Although the FCA determined that the seriousness of Barclays’ conduct reached Level 4 (out of 5) and thus attracted a 15% uplift of the total fine, Barclays qualified for a 30% discount by settling during Stage 1, being the point at which the FCA has communicated its assessment of the appropriate penalty and allowed a reasonable opportunity to reach agreement as to the amount of the penalty. The Gold Fixing is the process by which the price for settling contracts between members of the London bullion market is fixed. The fine arose from the FCA’s discovery that a Barclays trader had manipulated the Gold Fixing in order to avoid making a pay-out under an option contract whose value was determined by the price of the Gold Fixing on that date. This instance led to an investigation of Barclays’ general conduct in respect of the Gold Fixing. Barclays was fined for breaching Principles 3 and 8 of the FCA’s Principles for Businesses (the “Principles”). The breach of Principle 3 consisted of Barclays’ failure to take reasonable care to organise and control its affairs responsibly and effectively with adequate risk management systems. The breach of Principle 8 consisted of Barclays’ failure to adequately manage certain conflicts of interest between itself and its customers. In respect of the breach of Principle 3, the FCA concluded that Barclays had failed to: • provide staff with appropriate guidance or training concerning their participation in the Gold Fixing; • have measures allowing supervisors to monitor traders’ activities during the Gold Fixing; and • have policies and procedures specifically tailored to the Gold Fixing. In respect of the breach of Principle 8, the FCA concluded that, although Barclays had general policies that dealt with conflicts of interest, none of these provided sufficient guidance to inform traders or their supervisors about what types of conflicts of interest with customers could exist when they traded in the Gold Fixing and what they should do to mitigate those conflicts. In determining the level of the fine, the FCA considered that it should: • be significant enough to act as a deterrent; • reflect Barclays’ size; and • take account of Barclays’ disciplinary history (including involvement in the LIBOR and EURIBOR affairs). The FCA did, however, acknowledge that Barclays had voluntarily and fully compensated the client for its loss under the option contract, had brought the trader’s conduct to the attention of the FCA, had been co-operative in the investigation and had enhanced its systems and controls in relation to the Gold Fixing. 2. Invesco In April 2014, the FCA published a Final Notice imposing a financial penalty of £18,643,000 on Invesco Asset Management Limited and Invesco Fund Managers Limited (“Invesco”). The fine was levied on Invesco for exposing investors to greater levels of risk than they had been led to expect. In particular, Invesco did not comply with investment limits which are designed to protect consumers by limiting their exposure to risk. In addition, the firm did not clearly inform investors or explain the associated risks of its use of derivatives which introduced leverage into the funds, although the firm was allowed to use derivatives in this way. These failures constituted breaches of the FCA’s Collective Investment Scheme Rules, Principle 7 and various other FCA regulations and caused losses to Invesco funds of nearly £5.3 million. Prompt compensation was paid to the funds, but the FCA noted that the losses could have been greater. Although the FCA identified a relatively broad range of breaches, it determined that their overall seriousness only reached Level 2 (meaning an uplift of 5% on the amount of the fine). Amongst other reasons, this was deemed to be so because Invesco took steps to rectify systemic weaknesses as soon as it discovered Notable H1 2014 FCA Investigations H1 2014 UK Banking Litigation and Financial Regulatory Update | July 2014 page 12 continued on page 13 Notable H1 2014 FCA Investigations continued from page 11 them, the breaches of the COLL investment restrictions were each relatively self-contained and were not indicative of systemic failings, and none of the breaches were reckless or deliberate. When the FCA is calculating the level of a fine, it takes into consideration the revenue generated as a result of the breaches. This then serves as the figure to which a percentage uplift is applied depending on the seriousness of the breach. For the breaches of COLL, the FCA calculated the relevant revenue to be £516,261,380. However, as the FCA deemed that the breaches of COLL were relatively self-contained, it chose to exercise its discretion to reduce the amount of the fine after the percentage calculation had been applied. In this case, it chose to reduce the fine by 50% so as not to make the overall fine disproportionately large. Further, Invesco settled at Stage 1 and thus qualified for the 30% discount for early settlement. 3. Santander In March 2014, the FCA published a Final Notice imposing a financial penalty of £12,377,800 on Santander UK plc (“Santander”) for widespread investment advice failings. The FCA determined that there was a significant risk of Santander giving unsuitable advice to its customers, its approach to considering investors’ risk appetites was inadequate, and for some people it failed to regularly check that investments continued to meet their needs – despite promising to do so. Santander agreed to settle at Stage 1 and thus benefited from the 30% discount. Santander’s provision of investment advice was put into question partly by a “mystery shopping” review, where a third party is engaged to pose as a potential customer. The FCA found that Santander breached Principle 7 (communication with clients) by failing to: • Ensure that its advisers provided customers with appropriate disclosure about Santander, its products, services and associated costs; and • Pay due regard to the information needs of its Premium Investments customers (typically customers with funds in excess of £50,000) by producing financial promotions that did not satisfy the requirement to be fair, clear and not misleading. Santander was also found to have breached Principle 9 by failing to: • Ensure that its advisers gathered all necessary information from customers to enable suitable recommendations to be made; • Ensure there was an adequate process in place for assessing the risk that a customer was willing and able to take; • Ensure its advisers obtained all necessary information before making personal recommendations to customers; • Ensure that it provided customers with suitability reports which adequately specified their demands and needs; • Implement adequate procedures for monitoring the quality of investment advice and remedial action taken where advice had been found to be unsuitable or unclear; and • Ensure new advisers received adequate training before they started to give advice to customers. 4. State Street In January 2014, the FCA published a Final Notice imposing a financial penalty of £22,885,000 on State Street Bank Europe Limited and State Street Global Markets International Limited (together, “State Street”) for breaching Principles 3, 6 and 7. Although the FCA decided to triple the fine it would have given State Street in order to serve as a deterrent, settlement at Stage 1 allowed State Street to qualify for the 30% discount. The breaches in question concerned State Street’s transition management business in Europe and the Middle East (the “TM Business”). Transition management is the service by which a financial institution assists its clients to carry out major structural changes to their asset portfolios. State Street’s TM Business generated revenue in different ways, including commission on trades, taking spreads or mark-ups and fixed management fees. However, the FCA found that the TM Business had developed and executed a deliberate and targeted strategy to charge substantial mark-ups which had not been agreed with clients and which were not subsequently disclosed. In total, six clients were overcharged $20,169,603 between them. The FCA determined that State Street breached Principle 3 by failing to take reasonable care to organise and control its affairs responsibly and effectively with adequate risk management systems. In particular, State Street failed to put in place appropriate systems and controls around the TM Business to adequately mitigate the risk that employees would mislead and/ or overcharge clients. State Street was deemed to have breached Principle 6 (the duty to pay due regard to the interests of its customers and treat H1 2014 UK Banking Litigation and Financial Regulatory Update | July 2014 page 13 Notable H1 2014 FCA Investigations continued from page 12 them fairly) for a variety of reasons, including allowing a culture to develop in which customer interests were subordinated to the generation of revenue. Principle 7 says that a firm must pay due regard to the information needs of its clients and communicate information in way which is clear, fair and not misleading. State Street was deemed to have breached this Principle by allowing the TM Business repeatedly to provide clients with inaccurate, unclear and misleading information about the remuneration that State Street would earn on transitions and the charges and fees that would be levied. The FCA considered that State Street’s breaches reached the highest level of severity (Level 5) and therefore imposed an uplift of 20% on the fine. The reasons for this were given as follows: • State Street was prioritising generation of revenue over the interests of customers; • the savings and investments of retail investors had been jeopardised; • State Street had breached a position of trust; • the overcharging remained undetected until it was identified by one of the affected clients; and • State Street’s conduct caused a significant risk that financial crime would be facilitated. 5. Standard Bank In January 2014, the FCA fined Standard Bank PLC (“Standard Bank”) £7,640,400 for failure to comply with Regulation 20(1) of the Money Laundering Regulations 2007 (the “ML Regulations”). In particular, the FCA found that Standard Bank failed to take reasonable care to ensure that all aspects of its anti-money laundering (“AML”) policies and procedures were applied appropriately and consistently in relation to corporate customers connected to politically exposed persons (“PEPs”). The FCA reviewed Standard Bank’s policies and procedures and a sample of 48 corporate customer files, all of which had a connection with one or more PEPs. The results of this review highlighted serious weaknesses in the application of Standard Bank’s AML policies and procedures. The FCA found that Standard Bank had breached its obligations because it did not consistently: • demonstrate that all relevant risk factors had been taken into account when determining the level of money laundering risk that prospective corporate customers posed; • apply appropriate risk ratings to corporate customers given the identified risk factors; • carry out adequate enhanced due diligence measures before establishing business relationships with corporate customers that had connections with PEPs; and • conduct the appropriate level of on-going monitoring of existing customer files to ensure that information and risk assessment was up-to-date and that the activity on accounts was consistent with expected activity. The FCA considered that the severity of Standard Bank’s breaches reached Level 4, and as such an uplift of 15% was applied to the fine imposed. The FCA considered that the following factors aggravated Standard Bank’s conduct: • Standard Bank provided loans and other services to a significant number of corporate customers who emanated from or operated in jurisdictions which have been identified by industry recognised sources as posing a higher risk of money laundering; • Standard Bank identified issues relating to its ability to conduct on-going reviews of customer files but failed to take the necessary steps to resolve the issues; ands • The FCA has previously brought action against a number of firms for AML deficiencies and has stressed the importance of compliance with AML requirements.