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Claims arising from the sale of financial products

The Hong Kong Court of First Instance recently considered another claim by a client against a bank arising from the sale of a financial product. The Judgment in Li Kwok Heem John v Standard Chartered International (USA) Limited (formerly known as American Express Bank Limited) was handed down in early January 2016. In a lengthy Judgment, the Court considered a number of issues highly relevant to banks and other institutions engaged in selling financial products.

It is another victory for banks, following on the case of DBS Bank (Hong Kong) Ltd v Sit Pan Jit in 2015.

The claim

The claim arose from one of the Ponzi schemes operated by Mr. Bernard L. Madoff. Through the recommendation of the Bank, the claimant invested US$1,171,562.67 in August 2005 in Fairfield Sentry Fund (the “Fund”). The Bank received a distribution and serving fee of 0.5% per annum of the net value of the claimant’s shares in the Fund. The Fund turned out to be a Ponzi scheme. The claimant sued the Bank for (1) misrepresentation and (2) breach of duty of care.

The claimant is a chartered accountant and former audit partner of PricewaterhouseCoopers.  He is also a businessman and a private investor.

The false representations

The Bank’s staff gave the Fact Sheet and Update of the Fund to the claimant, and explained to him the history, past performance, investment strategy and rationale of the Fund and how it worked. 

The Bank’s staff told the claimant that over almost 15 years, the Fund had returned to clients a net compounded annual rate of 11.23% with a standard deviation of 2.6% and a Sharpe ratio of 2.65.  From January to June of 2005, the Fund delivered a net return of 3% with no down month.  It outperformed the S&P 100 Index which had a loss of 2% over the same period.  The Fund adhered to an investment policy of capital preservation, low volatility and long-term capital appreciation. The Bank’s staff told the claimant that the Fund was a low risk investment with moderate returns.

The claimant said that by way of necessary implication, the Bank’s staff had represented to him that the Fund was an authentic investment.

The Bank said that it had merely served as a conduit and relayed the representations of the fund manager in the Fact Sheet and Update to the claimant. The Bank said it only quoted these documents and did not purport to speak from independent knowledge. 

However, the Bank knew the claimant was seeking the Bank’s advice before deciding what investment decision he would make. In the circumstances, the Court held that the representations about the Fund, as contained in the Fact Sheet and Update, were not just made by the fund manager, but had been adopted and made on behalf of the Bank to the claimant.

In December 2008, Mr Madoff’s fraud was revealed, and the Bank adjusted the claimant’s investment in the Fund to a value of US$0.01.

False representations on the Fund had therefore been made on behalf of the Bank to the claimant. 

Duty of care

The Court further found that the Bank owed a duty of care to the claimant and was required to act with reasonable care and skill. While the claimant may be an experienced investor, he did not know the funds that were introduced to him.  He had to rely on the Bank’s advice.

Due diligence / negligence?

However, the Court said that the question is whether the Bank had been negligent in conducting the initial and on-going due diligence on the Fund and had reasonable grounds to believe and did believe up to the time when Mr Madoff revealed his fraud that the representations were true.

The issues of a claim based on a warranty (there may be evidence of an intention by one or both parties that there should be contractual liability in respect of the accuracy of the representations) or a collateral contract do not appear to have been considered.

A large number of points were made by the claimant against the Bank. However, the essential issue was that Court saw no reason why the Ponzi scheme could have been discovered if the Bank should have taken the actions alleged by the claimant. The claimant suffered loss because the Fund was a Ponzi scheme. However, there was no evidence to show that any failure on the Bank’s part had led to the claimant’s loss.

The claimant complained, among other things, that the Bank failed to consider why the Fund was consistently of low volatility and had been able to produce good returns. This was met by the production of an article in the press that did an analysis of a generalized options strategy of the kind employed by the Fund.  It concluded that such strategy could add value to an investment.  The Bank had also been assured by the fund manager that the trades done by the Fund  showed that the Fund was operating purely on the split/strike strategy and the trades could account for all the returns. The trade tickets had all been passed to the fund manager but were fictitious.

Industry practice was accepted by the Court. Thus in relation to the arrangement of the fund manager trading through an affiliated broker which may facilitate fraud, the Court accepted that this was not rare or unacceptable in the industry.  The fact that even after Mr Madoff’s fraud was exposed, about 20% of hedge funds still had such arrangements was accepted as exculpatory. 

As for reliance on the due diligence conducted by third parties, the Court said that if the auditors and custodian bank are supposed to work according to professionally acknowledged standards or code of conduct or declared principles which are acceptable, then unless there are matters that raise concerns about their reports, the financial adviser (the Bank) can safely rely on the reports without making any further enquiry. 

The claimant said that the Bank should have made a simple enquiry to the custodian bank on a periodic basis on whether they had check with an independent third party as to the existence of the assets of the Fund.  The Court however did not see the justification for requiring independent professionals to answer such “basic enquiries”.

In conclusion, the Court held that the Bank was not negligent in failing to discover in the initial or on-going due diligence that the Fund was in fact a fraud. The claimant’s claim therefore failed, although he succeeded on the “representation” issue.

Documentation / risk disclosure statement

The Court also made a number of rulings/comments about the documentation used by the Bank.

The Court said that nothing really turns on the lack of explanation of the Bank’s documents by its staff to the claimant. This is because the claimant admitted that with his professional experience and general experience in dealing with banks, he understood that the terms in the documents governed his relationship with the Bank. 

The Bank’s risk disclosure statement stated that the claimant will not rely on any communication of the Bank as investment advice or as a recommendation to enter into any transaction.  

The Court said that the risk disclosure statement covers high risks investment activities and not the Fund which is a low risk hedge fund.  Hence the risk disclosure statement did not apply to the claimant’s purchase of the Fund, and the Bank cannot rely on the risk disclosure statement to defend the claimant’s claim. 

The risk disclosure statement also stated that the Bank’s employees do not have authority to give the claimant advice about any transaction, and that the claimant may not rely on any statement made by any employee or agent of the Bank as advice or as a recommendation. However, the Bank‘s Business Conditions stated that the Bank may provide the claimant with information, advice and recommendations in respect of dealings in securities.  The Court said that these statements in the risk disclosure were inconsistent with the Business Conditions which governed the relationship between the claimant and the Bank, were repugnant to the intention of the parties, and were to be rejected. Furthermore, in the light of the fact that the Bank provided an Investment Adviser whose duty was to give advice to the claimant on investments, these statements in the risk disclosure were contradictory to the reality. 

The Court accepted, however, that these statements may be appropriate for clients who engage in high risk investments of a highly speculative element.

The Court further said that the risk disclosure statement is subject to the Control of Exemption Clauses Ordinance and the Misrepresentation Ordinance. While, the claimant may be an experienced investor having about 20 years’ experience in investing in equities, when it came to investing in funds, he could not tell which of the multitude of funds available from the Bank was suitable for him.  The Bank professed to be able to assist the claimant in satisfying his investment needs.  The Bank had a team of Investment Advisers whose duty and specialty was to provide advice and recommendations to clients on what investment decision to make.  But the risk disclosure statement sought to exclude the Bank’s liability from the very service that the claimant needed and the Bank provided.  The claimant had little choice in the matter.  The terms were in a standard form imposed on the claimant by the Bank.  He could not negotiate out of their severity or escape from them by going to another private bank as such terms were common in standard contracts of private banks. Therefore, the risk disclosure statement did not satisfy the requirement of reasonableness, and the Bank could not rely on its provisions to exclude or restrict its liability to the claimant.

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Banking and Finance

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