Misselling and Misleading – Acting for the Promoters of Financial Products
In these difficult economic times, the duties and liabilities of the promoters of financial products are coming under much tighter scrutiny. In the decade prior to the global economic recession, steadily increasing values in shares and property meant that promoters of such schemes rarely had to examine their potential liabilities, and conversely investors paid little attention to the available avenues of recourse in the event that they lost money.
Potential liabilities are now of keen interest for both promoters and investors, as in many cases the value of the capital invested in the product has been significantly reduced, or even wiped out. Most cases centre around three fundamental issues:
Misselling of financial products to investors; Failure to explain the terms of the product to investors; and/or Misleading statements made to investors. This article also considers the regulatory requirements associated with the selling of financial products.
SMDF v Bloxham
A recent and ongoing example is the case taken by Solicitors Mutual Defence Fund ("SMDF") against Bloxham Stockbrokers. The case is based on the investment by the SMDF of €8.4 million in a Dresdner bank bond in 2005. Morgan Stanley, who were recently joined to the proceedings as a third party on the application of Bloxham, arranged and dealt in the notes and issued them via an Irish special purpose vehicle. The global financial crisis resulted in the rating of the bond being down-graded, which constituted an "early redemption event" in the bond.
In June 2009, Morgan Stanley redeemed the bonds on the first date they could do so without incurring any losses on their part. The loss to the SMDF was 97% of the value of the funds initially invested.
The SMDF initiated legal proceedings in December of last year, contending that Bloxham failed to explain the true nature of the bonds and recommended the investment without properly understanding its nature and associated risks. In turn Bloxham have alleged that the losses were caused by, or at least contributed to, by Morgan Stanley. They also claim that Morgan Stanley did not give sufficient warning to them in relation to the possibility of early termination of the bonds.
Currently these proceedings have been adjourned by the Commercial Court until 5 October 2010. As of the date of writing, the last significant occurrence in the case was the joining of Morgan Stanley as a third party on the application of Bloxham.
Kilmartin v Bank of Ireland
This case, which received quite a considerable degree of media attention, provides another recent example of the misselling of financial products by financial institutions. The plaintiffs had been sold an endowment mortgage in 1991 by their bank manager in Bank of Ireland, on the basis that it would provide a "nice little nest egg" of approximately €14,000 after fifteen years, as well as paying off the £50,000 (€63,000) mortgage.
An endowment mortgage is a mortgage loan arranged on an interest-only basis where the capital is intended to be repaid by an endowment policy. The underlying premise with endowment policies being used to repay a mortgage is that the rate of growth of the investment will exceed the rate of interest charged on the loan. In this instance, the endowment policy had resulted in a shortfall of €4,864, which the plaintiffs had to meet from their pension when the policy matured in 2006.
The Kilmartins claimed that they suffered loss of over €22,000 as a result of the bank's negligent advice that this type of mortgage would provide the plaintiffs with superior security and return, when compared with a traditional annuity mortgage. Also, they alleged that the bank had failed to warn them of the risk attaching to endowment mortgages.
The bank's counsel stated that his client's position was very simple – the endowment mortgage had cost the plaintiffs approximately €5,000 less than an annuity mortgage, and therefore they had not been ill-advised. Also, the bank manager claimed he had warned one of the plaintiffs verbally of the potential risks before they entered the mortgage.
In a potentially far-reaching decision for the banks, the Circuit Court President, Mr Justice Deery, found in favour of the plaintiffs and awarded them €16,000 in damages on the basis of the bank's negligent misrepresentation.
The Court was satisfied that the documentation supplied to the Kilmartins had not contained language highlighting the investment risks involved, or the potential risk to one's home. On the contrary, the documents suggested there was no risk.
In response to the bank manager's claim that he had warned one of the plaintiffs about the downsides of an endowment mortgage over the phone, the judge dismissed this argument as it would have been natural to have repeated the warning in a follow-up letter of 2 May 1991 and the manager had not done so.
As a result, the Kilmartins were awarded €16,002, broken down as follows:
€6,039 for the shortfall on maturity of the mortgage; €1,963 for additional premiums and interest; and €8,000 for loss of projected surplus. More worrying for the banks than the amount of this particular award is the number of similar claims which are alleged to be working their way through the Courts. While many may be statute-barred, those who only became aware of financial losses within the last six years will have an arguable case on the basis of this precedent. Bank of Ireland have appealed to the High Court, and the case is due to be heard in December 2010.
Liability of Investment Managers:
Investment managers operating in Ireland owe specific duties to clients when providing investment management services. These duties differ from those of other service providers operating in the financial services industry, such as custodians and administration companies. The main headings, under which an investment manager owes legal duties to clients and the potential heads of liability to those clients for losses arising, are as follows:
A disgruntled investor may claim that an investment manager has acted negligently in providing services to the investor. As with all negligence-based actions, for such a claim to succeed, the investor will have to establish duty, breach, causation and loss.
An investor can usually establish the existence of a duty of care, due to the nature of the investment manager-client relationship (under the usual headings of proximity, reasonable foreseeability, and whether it is just and reasonable to impose liability). Where a duty of care exists, an investment manager must observe the applicable standard of care. Failure to do so constitutes negligence.
Investment managers will seldom guarantee the client a particular outcome, because the value of investments may rise and fall due to factors beyond their control. Nevertheless, the investment manager has a duty to use reasonable care and competence when carrying out its activities. When this standard is not adhered to, the client has a potential basis for a claim in negligence.
Put simply, the applicable standard of care is whether the investment manager provided the service with the proficiency of an ordinary skilled person in that sector. An investment manager would also be liable if it conducted a service which it was not competent to provide. Common practice in the sector is relevant to making a determination of negligence, so long as the practice is not deemed inherently defective. When the investment manager is regulated, the applicable regulatory standards are also relevant to determining negligence, as we will discuss in greater detail below.
Special rules apply to cases of "professional negligence". For example, claims for pure economic loss are more likely to succeed in cases of professional negligence. Furthermore, the courts hold professionals to a higher standard than non-professionals when determining whether a breach of duty of care has occurred. The Irish courts have yet to exhaustively define what constitutes a "profession" for professional negligence purposes. It is not clear that investment management is a profession for negligence purposes in Ireland. The English courts have indicated that an independent financial adviser is a profession.
While the above principles are well established in both Irish and English case law, it is important to note the Irish courts can be quite harsh in applying these principles to professional service providers. The Irish Supreme Court has, for instance, ruled in the Wildgust v Bank of Ireland case that a life insurer was liable to the plaintiff policyholder for informing a third party bank, which had a security assignment over the policy, that the premiums on the policy were paid up-to-date when in fact a payment had been missed.
Even though the bank never advised the plaintiff of this conversation, so that he did not rely on it, the insurer was...