Banks are bound to get caught up in legal battles as fund managers try to claw back losses. Jonathan Brogden, partner at Davies Arnold Cooper, and Simon Hodgson, solicitor, discuss the possibility of court action…
Litigation stemming from the credit crunch will most probably turn the spotlight on misrepresentation as fund managers will look to either escape liability or recover losses from unprofitable agreements.
Defaulting bonds provide a useful example for examination of these issues. Banks that sold bonds that subsequently defaulted will inevitably be sized up as potential targets by investors looking to recover losses.
Those banks will point to contractual terms and disclaimers in defence of any claims made against them. Two types of clauses consistently included in the contractual terms are entire agreement clauses (EAC) and non-reliance clauses (NRC).
In simple terms, an EAC asserts that the written contract represents the entire agreement and understanding between the parties. An NRC declares that the investor has not relied on any representations made outside the four corners of the contract.
In the event of a dispute, these clauses are relied upon to negate reliance on pre-contractual representations, such as those made in sales pitches.
The EACs and NRCs will inevitably come under scrutiny in the event of litigation. Over the past couple of years there have been a number of cases that provide useful guidance to anyone involved in a misrepresentation claim. The decision in Quest 4 Finance v John Maxfield and Others [2007] is helpful to the party bringing a claim for misrepresentation, such as a fund manager seeking to dent the perceived invulnerability of the banks from litigation for mis-selling bonds that subsequently default.
Conversely parties such as banks, faced with such a claim and seeking to rely on EACs and NRCs will be able to draw comfort from the judgement in JPMorgan Chase Bank and others v Springwell Navigation Corp [2008]. This decision is especially helpful to a bank facing a claim by investors who are clearly sophisticated investors with a history of operating in the financial markets.
Perceived invulnerability
Banks and other financial institutions that sold the myriad of securities that have been stripped of their value in the sub-prime mortgage fallout may have previously believed themselves invulnerable from litigation due to a combination of a number of factors.
They relied on EACs and NRCs, as well as on the apparent sophistication of the institutional investors purchasing the debt. Furthermore, the banks believed that the disclosure requirements themselves, such as filing of accounts in the IFRS format and setting out business risks in detail, further insulated them.
In reality, none of these arguments will stand up to fraud. Whether they will hold water in the event of a misrepresentation will depend upon the facts of each case.
Springwell
The Springwell case mentioned earlier sets the high water mark needed for a claim to overcome an EAC and NRC. This concerned investment by wealthy Greek shipowners in Russian market debt instruments, which defaulted in 1998 incurring circa $500m in losses. This claim foreshadows the type of claims envisaged flowing from the losses associated with collateralised debt obligations in 2007-2008. Springwell alleged that there had been a misrepresentaion by JPMorgan Chase Bank about the suitability and financial security of certain Russian securities.
The contracts in the Springwell case contained both EAC and NRC clauses which set out that JPMorgan Chase Bank was not assuming responsibility for any statements of fact made outside the contract and that Springwell had not relied on any such advice when making its decisions. The judge found that these clauses precluded any claim that Springwell had in fact relied on
such misrepresentations. Where parties incorporate the agreed state of affairs into the contractual documents, neither can subsequently deny the existence of the facts and matters upon which they have agreed.
As a result, even though the judge found that there were statements in the contracts that did not accurately reflect the reality of the relationship between the parties, she found this could have no bearing on the outcome of the case.
Quest for finance
Quest also considers the effect of an NRC in the context of a misrepresentation. Unlike the decision in Springwell, the claim based on misrepresentaions made outside the four corners of the contract was successful. This was despite a clearly worded NRC which set out to preclude this exact type of claim.
The case involved John Maxfield, one of the directors for Hilmax Engineering Limited, approaching a broker who worked for Quest for the provision of finance. Maxfield explained to the broker that the directors were unwilling to provide personal guarantees. The broker confirmed that no personal guarantees would be required and provided Maxfield with a brochure detailing a financing option, which stated: “Importantly, no personal guarantees are required from company directors, and no charges are taken over the company.”
In fact, in accordance with the finance contract requirements, personal warrantees were entered as a separate document. These indemnified Quest for all and any losses of Hilmax’s breach of warranty, which were in the nature of a personal guarantee. Quest sought to rely on the seemingly unequivocal NRC, which said that in entering into the contract Maxfield had not relied upon any advice of any person representing the interests of the Quest.
In determining what effect to give to the NRC the judge applied a three-stage test following Watford Electronics Ltd v Sanderson [2002]. Quest had to demonstrate that the NRC is clear and unambiguous. The firm also had to prove that the party providing an NRC, in which they claim they did not rely on any statements outside the contract, intended for the recipient to rely on the NRC. Alternatively, it had to show that the party providing the NRC acted in a way that any reasonable person would believe the NRC to be true. Quest also had to show that the recipient in fact believed that the investors did not rely on any outside statement.
The last element results in a high threshold, which may in practise thwart the effectiveness of the NRC in instances where misrepresentations were made that were clearly intended to be relied on in encouraging the other party to enter into a contract. It was this element of the test that Quest failed, enabling Maxfield’s claim for misrepresentaion to succeed.
In an ordinary case, the courts will adopt a robust approach to NRC’s upholding the agreed contractual terms. However, the inclusion of an EAC and/or an NRC does not shut the door on a misrepresentation claim entirely. A misrepresentation claim will be more likely to succeed in certain instances, despite the inclusion of an EAC and NRC. Cases in point are when the misrepresentation is clear and unequivocal or when it concerns matters of importance to the parties. Another example is when the party that makes the misrepresentation is unable to demonstrate a belief that the other party’s declaration of non-reliance was true.
©2009 Funds Europe
