The worst case scenario: Court of Appeal clarifies the extent of the duty to explain risks of a product to customers

Background

When selling a financial product to a business customer, how much information does the seller have to provide to the buyer? Banks owe a common law duty to ensure that, if an explanation about a product is provided, the terms are not misstated. But when providing such an explanation, where should the bank draw the line? How much information needs to be provided about the risks when the bank's role is non-advisory and the customer is a business? And can omitting certain information about the risks constitute a misstatement of the terms of the product? For instance, the bank is likely to have carried out its own detailed analysis of a transaction before it enters into it – not least to ensure in advance that the likely risks and profit margins are acceptable to the bank. How much (if any) of that information does the seller have to share with the customer? This was one of the key questions considered recently by the Court of Appeal in the Property Alliance Group judgment.

Between 2003 and 2008, Property Alliance Group (PAG), a property development business, obtained a series of loans from RBS. Each loan was linked to an interest rate swap product sold by RBS (the Swaps) which had the effect that PAG would be protected from rises in interest rates but would be worse off if interest rates fell. The Swaps could be cancelled on notice, but that would incur break fees (the Break Fees) calculated in accordance with a formula set out within the terms agreed by the parties. In advance of entering into the Swaps, RBS produced its own internal analysis of the possible worst case scenario for PAG if interest rates moved against PAG (the Internal Calculations). The Internal Calculations were not shared with PAG by RBS. When interest rates collapsed, PAG was exposed to significant ongoing losses under the Swaps. In 2011, PAG cancelled the Swaps to stem its losses but incurred the Break Fees in excess of £8m.

Judgment

PAG sued RBS on the basis that (inter alia) RBS had failed to provide PAG with enough information about the potential Break Fees, including in particular the Internal Calculations, and that omission amounted to an incomplete explanation of the Swaps and therefore a negligent misstatement by RBS. The Court of Appeal held that, if the seller does proffer an explanation to the customer, then the seller owes a duty to give that explanation as fully and as accurately as possible. However, the Court confirmed that the existence and the extent of that duty are dependent on the facts of the particular case. In this case, the statements made by the parties and relationship between them was such that there was no obligation on RBS to disclose the Internal Calculations and failure to do so was not an omission constituting a breach of the duty not to misstate. In particular, RBS made PAG fully aware that breaking the Swaps would have adverse financial consequences and, even though the Internal Calculations were not provided, RBS notified PAG in advance how the Break Fees would be calculated.

Comment

For those selling financial products to business customers, there are three key lessons from the Court of Appeal's judgment:

1. If the seller explains the terms, the seller owes a duty to ensure that explanation is accurate and not misleading. Whether a statement (or omission) constitutes a misstatement will depend on the facts of the case and whether the relationship between the parties is such that the bank has assumed responsibility for the client giving rise to a duty of care. To consider whether a duty of care arises, it is therefore necessary to look at both what was said (or omitted) and the circumstances in which it was said (or omitted).

2. In terms of what was said in this case:

a. RBS provided risk warnings and, crucially, set out clearly the formula which would be used to calculate the Break Fees. That explanation was deemed by the Court to meet the test of being full and as accurate as possible, even though the Internal Calculations were not provided. However, banks should err on the side of caution: if an explanation is to be provided at all, the risk of providing too much information is far less than the risk of providing too little; and

b. RBS's position was assisted by the fact that PAG represented (as part of standard acknowledgment documents provided to PAG by RBS) that it understood and accepted the risks of the Swaps and was capable of assuming those risks. Banks should ensure that, in addition to providing adequate information and risk warnings, their clients are also providing in return (as part of the bank's own standard documents) reliable written representations about having understood and accepted the risks.

3. In terms of the circumstances in which the statements were made, PAG was considered by the Court to be a relatively sophisticated entity which was entering into a commercial (and speculative) transaction with the bank with the assistance of professional advice from specialist derivative advisers who were capable of computing the risks for PAG. That is a very different scenario to that of an unsophisticated client without independent advice or a shell company SPV which holds assets for an unsophisticated high net worth individual, for whom the bank is much more likely to be deemed by the Court to have assumed a wider duty of care and therefore likely to be held liable to that customer for its statements and/or omissions concerning the products that the customer is acquiring.

If you require further information please contact Kate Allass or Jolyon Connell, or your usual contact at the firm on +44 (0)20 3375 7000.

This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.

© Farrer & Co LLP, June 2018