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UBS AG (London Branch) and another v Kommunale Wasserwerke Leipzig Gmbh; UBS Ltd v Depfa Bank plc; UBS AG (London Branch) v Landesbank Baden-Wurttemberg
A Leipzig municipal water company (KWL) sold credit protection to the investment bank (UBS) and to two other banks (LBBW and Depfa) on four portfolios of investment grade bonds and other securities. It did so by means of a series of derivative products known as single tranche collateralised debt obligations (STCDOs). Defaults occurred following the global financial crisis of 2008–9, and UBS, LBBW and Depfa sought payment of sums due under the STCDOs. The Commercial Court made rulings concerning, among other things, the availability of rescission to the parties.
In 2006 and 2007, UBS entered into derivative contracts with KWL. Under these contracts, KWL sold credit protection on four portfolios of investment grade bonds and other securities to UBS and LBBW and Depfa via STCDOs. Under the terms of these contracts, if any ten reference entities defaulted in eight to ten years, KWL would be liable to pay the banks millions of dollars. In 2008 and 2009, during the financial crisis, there were significant defaults on the underlying reference entities and KWL was, therefore, liable to pay significant amounts to UBS, LBBW and Depfa.
Fraudulent statements were made by H, a director of KWL in the process of setting up the STCDOs. H had been bribed by two consultants at Value Partners (VP), who purported to be KWL's financial advisers. UBS was aware of the conflict of interest that VP had in acting for KWL—for example, VP emailed its key contact at UBS, Steven Bracy (B), and asked for compensation for recommending UBS Global Asset Manager (UBS GAM) as its portfolio manager, which B did not notify KWL about. KWL also alleged that UBS had made fraudulent misrepresentations including:
It was also argued that the marketing of the STCDOs had not been conducted in a way that was fair, clear and not misleading.
Depfa contended that it had entered into the contracts because of misrepresentations that UBS had made which induced it to enter the contracts and these contracts should, therefore, be rescinded.
KWL claimed the STCDO was null and void as its managing directors, H and S, had acted outside their authority in entering the STCDO without supervisory board and/or shareholder approval. It was discussed whether UBS was grossly negligent in failing to realise that such approval should be sought. However, UBS had relied upon a capacity opinion prepared by a law firm which stated that KWL did have capacity to enter the transaction. UBS did not have sight of the legal opinion prepared by the law firm to KWL which said that the requirement of supervisory board approval was open to question. The judge found that:
H had been paid a bribe by VP for KWL to enter into the STCDOs. KWL stated that the STCDO was therefore voidable and avoided as a result of this bribe. UBS was not aware of this bribe (not even B). However, VP was acting as agent of UBS. KWL had been introduced to UBS as a client of VP and so VP was certainly acting as KWL's agent but it also acted as UBS's agent. VP's purpose was to procure KWL to enter into the STCDO with UBS. Payment of the bribe was within the scope of the agency relationship between VP and UBS, even though UBS was not aware of and did not authorise such payment.
KWL contended that, because of the close relationship between VP and UBS, VP were unable to give KWL disinterested advice. The judge accepted this view.
KWL also claimed that it was induced to enter into that STCDO by misrepresentations made on behalf of UBS in the course of the negotiations including that:
It was also argued that the marketing of the STCDOs had not been conducted in a way that was fair, clear and not misleading. Fraudulent misrepresentation requires a high threshold to be satisfied and the judge dismissed this claim.
UBS sought to recover damages for breach of warranty and fraudulent misrepresentations made by H on behalf of KWL. However, the judge found that the misconduct did not result in UBS' losses and that the losses were caused by the unenforceability of the STCDO and not by the fraudulent statements made by H.
Depfa had relied upon misrepresentations when entering the swaps. Depfa and LBBW were entitled to rescind the contracts and return the sums that had been spent as a result of entering the transactions. However, they could not suffer a windfall and so had to also terminate the front swaps that they had in place so they did not benefit from only one side of the transaction—they had to rescind both sides.
The judge described the case as ‘a case study in how not to conduct investment banking in an honest and fair way’. The emphasis in his judgment is on how a prudent banker should operate and how it should have focused on potential corruption and capacity, rather than solely on profit. A bank should be careful to check that its counterparties have authority to enter transactions and fully understand any transaction it is entering into. It should also ensure that any agents acting on behalf of its counterparties are not also acting as their own agent if there is a risk of a conflict of interest existing as a result of these relationships.
The judge was scathing in his comments on how the portfolio manager, UBS GAM, had acted, stating that if there had been no portfolio manager at all, the outcome would have been better. The portfolio manager in charge of the relevant contracts was inexperienced and did not adhere to the standards and contractual obligations set out in the relevant portfolio management agreements (PMAs). Further, the portfolio manager did not fully appreciate the different measures of risk, focussing solely on ratings provided by rating agencies.
PMAs typically contain similar undertakings whereby the portfolio manager agrees to adhere to a certain standard of care followed by prudent institutional portfolio managers of international standing managing similar portfolios and should follow its customary procedures, policies and standards. This was the case in each of the PMAs signed by UBS GAM in relation to these transactions. UBS GAM should have ensured that, above all, if a default was likely to occur on the relevant reference entities, such reference entity was removed from the portfolio since that was the premise upon which KWL had entered into the derivatives—to take a conservative management approach by minimising the risk of default. By not doing so, UBS GAM was in breach of its obligations.
Portfolio managers must, therefore, ensure they follow a strategy that is wholly appropriate for their clients. Where a client enters a derivative transaction with the intention of potentially making significant sums, a portfolio manager may be required to take a more risky approach to its selection and management of reference entities within the portfolio. However, where a client is entering a derivative transaction with the intention of maintaining its position for a significant number of years and minimising risk, a conservative approach must be taken. This is in line with what a portfolio manager usually agrees in a PMA in the 'standard of care' section. Where a portfolio manager agrees to adhere to its own procedures, policies and standards, it must ensure that it does so. If it does not, it opens itself up to being in breach of its obligations.
The key lesson that can be learnt is the importance of having independent control functions within a bank. The credit department at UBS had acted responsibly and had flagged that they were not happy with the transaction being suitable for KWL. The credit department insisted upon intermediaries acting in some of the transactions (Depfa Bank and Landesbank). Control functions are important in banks for a reason and their advice should be listened and adhered to. The judge said that he hoped the events related to a 'bygone era' implying that banks are even more aware of their duties to act honestly and with integrity since the credit crunch.
Other important lessons to take away from the case include:
UBS has said that it will appeal the decision.
Emma Millington, solicitor in the Lexis®PSL Banking & Finance team.
First published on LexisPSL Banking & Finance. Click here for a free trial.
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