Where Will the Credit Crunch Bite?

The reality is that with every economic downturn, litigation lawyers start positioning themselves for a slice of the resulting litigation action. An economic slump usually leads to more disputes. But just as the catastrophic financial meltdown has its unusual distinguishing features, lawyers now cautiously theorise as to whether it will bring with it the traditional upsurge in litigation, or whether the dearth of disputes will be the commercial litigator's very own "black swan".

What we do know is that those that have suffered losses will seek to make somebody culpable. Not only have losses resulted directly from the credit crunch, perhaps through ill-advised investments in financial products or the nationalisation of banks, but losses will be caused indirectly. For example, companies that are suffering financially may look to terminate unprofitable contracts, employers will make employees redundant, creditors will refuse or be unable to repay their debts. It is usually safe to assume that these types of consequences will lead to an increase in disputes.

This article will examine where there is potential for litigation because of the credit crunch and consider measures that entities and individuals can take to recover those losses or prevent claims.

Property

The most obvious place to start is the property market where the genesis of this crisis began as a result of the disastrous sub-prime mortgage debacle. With the property market now in a steady decline, litigation is likely to arise in a number of ways:

• repossessions as a result of homeowners and landlords failing to meet their mortgage payments. We know, for example, that Northern Rock, now state-owned, is repossessing homes at twice the industry average with 4,201 homes already being seized this year as opposed to 2,215 at the end of last year. In the case of Royal Bank of Scotland v Luwum [2008] EWCA Civ 648, the Bank of Scotland applied for a possession order against a defaulting customer despite having agreed with the customer to allow him a period of three months to reduce the account below the overdraft limit. Luckily for the Defendant, the Court of Appeal decided that the bank was estopped from commencing possession proceedings within that three-month period because of the promise it had made.
  


• landlords taking action against tenants for failures to pay their rent
  


• claims arising from failure to comply with contractual deadlines for development projects due to the lack of ready capital to fund the projects
  


• surveyors may now be pursued more rigorously for negligently valuing properties. The property crash of the nineties produced a spate of such cases which limited surveyors' liability for losses caused purely through falls in market value, but they will still be responsible for more basic errors. For example, in the case of Platform Funding Limited v Bank of Scotland plc (formerly Halifax plc) [2008] EWCA Civ 930 a surveyor was held liable to the mortgagee bank for failing to exercise care and skill when carrying out the valuation of a property – as a result of the borrower's fraud the surveyor valued the wrong property. The Court decided that the surveyor had an unqualified obligation to locate and inspect the right property, even where fraud is involved. Whilst this decision may appear harsh, surveyors would do well to obtain detailed instructions from the lender and the borrower about the property and consider what caveats need to be inserted in any agreement with their clients.

Banking - Claims Against Banks

It seems inevitable that there will be a raft of claims flowing against banks and brought by banks as a result of the upheaval in the financial markets.

Customers who have engaged financial institutions to make investments on their behalf will also no doubt be seeking to recoup their losses as a result of the collapse in the value of those investments. A recent judgment handed down by Mrs Justice Gloster will throw some light on the merits of these types of claims, even though the case related to investments made in the 1990s. JP Morgan Chase Bank v Springwell Navigation Corp. [2008] EWHC 1186 (Comm) concerned investments made by JP Morgan on behalf of a customer in GKO-linked notes which suffered a disastrous decline in value as a result of the Russian economic crisis in 1998 in which the customer lost approximately $700m. Springwell, an investment vehicle for the wealthy Polemis family of Greece, alleged that it had suffered loses as a result of negligence for failure to advise as to the suitability of, and risk associated, with the investments in the emerging markets, as well as claims for breach of fiduciary duty.

Gloster J ruled in favour of the bank, the key points to note from the judgment being as follows:

• The Polemis family were experienced investors and had equal bargaining power with the bank. Furthermore, the customer had consented to being classified as a non-private investor (so it could invest in emerging markets), which therefore deprived it of the benefit of any regulatory obligation on the bank to ensure that the products sold were suitable for the customer's requirements.
  


• The relationship between the bank and customer was one of principal to principal; the bank was not an advisor. The contractual documentation was unambiguous, and Gloster J ruled that the customer could not argue that it could avoid being bound by the agreement in which it confirmed on several occasions that it would make its own investment decisions and not rely upon the bank when doing so. The Court upheld that decision in IFE Fund v Goldman Sachs International [2007] EWCA which recognised that the parties could, by appropriate language, exclude any parallel or freestanding common law duty of care. In the Springwell case, there was found to be no duty of care.
  


• Gloster J also considered whether the contract fell within the scope of the Unfair Contract Terms Act 1977 and should be regarded as an unreasonable attempt by the bank to exclude and/or limit its liability for negligence or breach of contract. She ruled that, in fact, the contract did not do this, but rather set out the scope of the bank's services – limited though they may have been. However, her view was that in any event the contractual relationship was one where the parties had equal bargaining power and therefore it should be left to them to negotiate and allocate risk as they felt appropriate; it was not for the court to interfere in that sort of bargain.
  


• Springwell had claimed that JP Morgan has breached fiduciary duties by taking advantage of the Springwell representative's lack of experience in order to offload unwanted bonds and also by failing to seek consent or failing to disclose the excessive profits they received. Gloster J ruled that in light of the fact that there was no advisory relationship, the bank could not have owed any fiduciary duty.

Whilst banks may breathe a sigh of relief at this decision, it must be made clear that this case was very much decided on the facts. The Polemises were sophisticated customers and the bank had the contractual documentation in place to support its position. This will not be the situation in all cases. Therefore unhappy investors will need to give careful consideration to the contractual documentation before bringing a claim, as well as their own experience and what they understood to be the obligations on the bank. On the flip-side a bank needs to ensure that its contractual documents make certain that the nature of any relationship with an investor is carefully delineated.

In addition, major financial institutions are likely to start thinking about issuing claims against each other, a practice that had not been prevalent before the credit crisis. For example, Barclays has recently re-filed its claims against Bear Stearns in the US (adding Bear Stearns' new parent, JP Morgan as a defendant) accusing Bear Stearns of systematically hiding losses in a fund which swallowed $400m (£251m) of the British bank's money. The fund had to be bailed out after reaching the brink of collapse following a disastrous series of investments in mortgage-backed securities.

Many of these inter‑bank disputes will give rise to complex jurisdictional questions. For example, HSH Nordbank, one of Germany’s biggest banks, sued UBS, the largest Swiss bank, in New York for losses of over $200million arising from collateralised debt obligations ("CDO"). HSH accused UBS of putting risky American mortgages instead of low-risk assets into a CDO that it sold to the German bank in 2002. UBS in turn filed proceedings in England for negative declaratory relief (as well as a Motion to Dimiss in New York) arguing that England was the appropriate forum for the dispute. The English court recently decided upon this issue and ruled that New York was the correct forum for the dispute, thus dismissing UBS' action.1

In that case, the Court considered a number of contracts between HSH and UBS governing various different investment arrangements. There was an agreement between the parties about the management of assets forming a particular reference pool and a contract for the exchange of puttable medium term notes. The reference pool agreement contained a non-exclusive New York jurisdiction clause and the medium term notes contract had an English exclusive jurisdiction clause. HSH had sued in New York under the reference pool contract, which the English Court ruled meant that the English jurisdiction clause was inapplicable and so the dispute fell within the New York jurisdiction.

There will no doubt be other disputes where the parties will seek to forum‑shop for the most favourable jurisdiction. Parties now negotiating deals where there will be a complex relationship or multiple contracts should ensure appropriate and definitive jurisdiction clauses are included. If a party wishes to ensure disputes are litigated in a certain jurisdiction, an exclusive jurisdiction clause should be utilised.

Claims in Insolvency Proceedings

The fact that some financial institutions are now the subject of insolvency procedures will itself increase the involvement of the court, the most obvious example being Lehman Brothers. Indeed, hedge fund RAB Capital ("RAB") has already made an application to court against Lehman's UK liquidators, PricewaterhouseCoopers ("PWC"), to try to reclaim $50m (£31m) of its assets held by the failed bank. The claim concerns the status of $50m of US Treasury Bills that RAB deposited with Lehman as part of its prime brokerage agreement. Prime brokers lend hedge fund shares and other securities in return for collateral, usually in the form of a stable, liquid asset like Government bonds. RAB accepted, as is usual custom, that Lehman as the prime broker had the right to use the collateral for its own needs. However, RAB argued in the proceedings that a subsequent agreement excluded those bonds from the wider arrangement, stating that they should be kept separate, which would mean RAB should be entitled to get them back in advance of the other hundreds of unsecured creditors.

A preliminary hearing in September of this year on this matter dealt with RAB's request for the High Court to consider its case urgently because RAB needed to publish the fund's Net Asset Value on 1 October 2008.2 RAB argued that it would have to suspend its valuation, if its action was not fast-tracked, meaning that it would, amongst other things, be harder for investors to sell their stakes in the fund. Whilst the judge did have considerable sympathy with that argument, he was not prepared for the courts to interfere with the administration process, and it was for the administrators of Lehman, not the courts, to decide what to do with the money owed to creditors. Mr Justice Morgan also stated that to allow RAB's case to be prioritised would invite an avalanche of claims from all other Lehman creditors. Whilst RAB were granted the right to appeal by the court, it appears this was not pursued. However, sooner or later the administrators themselves will no doubt be seeking directions from the court on various issues of priority between creditors or groups of creditors, who are no doubt already seeking advice as to how to advance their claims ahead of others.

More recently, another four hedge funds went to court to try to force PwC to provide more information about their holdings. PwC argued that the position of the hedge funds was not unique, that they had provided them with the information which was readily available about the securities and they should not be required to divert resources into making further investigations in relation to the hedge funds' securities (as an exception to their approach to trust claims generally). The court sided with PwC and was unwilling to dictate to Lehman's administrator how it should conduct its function where there was no evidence that it had been acting unfairly or improperly. It is highly likely that this will not be the last of the court proceedings PwC will face. 3

The process of clarifying the respective rights of creditors through applications to the court by officeholders of insolvent companies is already under way in relation to a number of structural investment vehicles (SIVs) to which receivers have been appointed. For example, Cheyne Finance plc and Whistlejacket Capital Ltd have both been the subject of applications for the English Court for directions under section 35 of the Insolvency Act 1986, notwithstanding that those companies are incorporated in Ireland and Jersey respectively.

In Re Cheyne Finance plc (No. 2) [2008] IBCLC 741 the Court considered the test for determining whether there had been an 'insolvency event'. Should it be defined by reference only to the company's ability to pay those notes that were due for payment or did its ability to pay all its senior debts as they fell due have to be taken into account? The Court decided in favour of the latter approach. In Re Whistlejacket Capital Ltd [2008] EWCA Civ 575 the Court of Appeal similarly denied an advantage to holders of short‑term notes by deciding that unpaid notes which had fallen due before the insolvency did not have to be paid in full and the receivers  had a discretion as to when to apply monies towards discharge of the company's debts.

Other Crunch‑related Litigation

Nationalisation of banks and financial institutions has left investors seething with anger. The nationalisation of Northern Rock, for example, led to an outcry from shareholders and to threats of litigation demanding compensation for their loss of shares. Shareholders have a number of options in which to try to claw back their losses in the event of nationalisation including:

• judicial review of any Government compensation scheme. In the case of Northern Rock the scheme determined that an independent valuer would value the shares immediately before the transfer based on the assumption that Northern Rock is unable to continue as a going concern and is in administration – unlikely to yield much by way of a share price
  


• an action for illegal expropriation of property by the Government
  


• a misfeasance in public office claim against the Chancellor of the Exchequer

Perhaps the most likely avenue to yield a positive result for the shareholders is the judicial review approach. This path has been chosen by Northern Rock's largest shareholder SRM Global Fund and the UK Shareholders Association (representing the interests of approximately 150,000 small private shareholders). The shareholders' case is that the compensation scheme has been unfairly formulated so as to result in negligible compensation being paid, despite the fact that the British Government has acquired a solvent and profitable business with the clear intention to sell it on in the future at a profit. The shareholders will argue that the Government's action was unprecedented and therefore the case will focus on the reasoning and conduct of the Government leading up to the nationalisation.

Governments may  also seek to protect their own citizens as a result of the credit crunch. In Britain, many citizens invested their money in high interest internet accounts with Icelandic banks. With Iceland now on the brink of bankruptcy, those ordinary savers must wait to see if they will recover their hard-earned savings. Gordon Brown has let it be known publicly that he would take legal action against Iceland for not undertaking to recompense those UK investors. Once it was clear to the Government that Iceland was not committed to compensating British depositors, the British Government seized certain Icelandic assets amounting to £4bn (more than enough to pay back the British savers). Interestingly (and perhaps alarmingly for foreign governments) Britain used anti-terror legislation to freeze these funds by arguing by passing an Order pursuant to the Anti-terrorism, Crime and Security Act  2001. This was on the basis that the HM Treasury  reasonably believed that action to the detriment of the UK's economy (or part of it) has been or is likely to be taken by persons who are the government or resident of a country or territory outside the UK. 

This in turn has led to a legal showdown between Iceland and the British Government with Iceland now instructing English lawyers to explore options for potential damages claims against Britain as well as potential judicial review proceedings (to overturn the Government's decision to seize control of, for example, Kaupthing Bank's British arm). Kaupthing claim that the decision to freeze its British arm's assets caused a run on the parent bank that led to its collapse.

Most recently, whilst the investigation commmences on how Bernard Madoff was able to hide one of, if not, the biggest frauds of all time, discussion is ongoing in the legal community as to whether the Securities and Exchange Commission (the SEC) could be held to account by the victims if it is found that the SEC could have done more to prevent the fraud

General Increase in Litigation

Finally, inter-company disputes seem likely to increase. A simple fact is that as the revenue of companies decline and they are unable to secure funding from alternative sources, they will renege on commitments – be they to repay debts or perform contractual obligations. One area where litigation may arise is in relation to companies trying to resile from bad deals. A potential scenario is as follows: Company A may be in the position of having to purchase materials at a specified price from Company B which means Company A is working at a loss (due to its inability in the current climate to pass on the full cost to its own customers). Company A cannot continue to perform the contract without bankrupting itself so it is refusing to perform. Company B would suffer catastrophic losses as a result of the non-performance of Company A. If Company B is unwilling to renegotiate the terms of the deal to make it more favourable to Company A, then what options does Company B have?

• On a practical level, Company B should immediately start thinking about whether it can find alternative customers. If an alternative can be found at a lower but acceptable price then Company B could accept the repudiatory breach of Company A and sue Company A for the difference in the contract price (and for any other loss suffered).
  



• If there is no alternative to Company A, then Company B should consider injunctive relief by was of specific performance. Specific performance is an order from the court that requires a party to perform a specific act. Historically, the courts have not been keen to grant specific performance in contractual disputes where such an order would require constant supervision of the performance under the contract. In a case such as this, the Court would have to carry out various balancing exercises, for example, whether ordering specific performance on Company A would cause it severe hardship as compared to the damage suffered to Company B; whether Company A had misbehaved; whether there is mutuality of obligations, and whether there would too much of a burden on the court to monitor the contractual performance.

Comment

The future is still very much uncertain. Litigation will inevitably flow from the economic crisis, but whether there will be an avalanche is still difficult to say. For example, recent figures from the Ministry of Justice have shown that in 2007 the number of civil cases issued in the High Court was only 1.6 per cent higher than the previous year (even though the economy showed signs of deterioration towards then end of 2007). It remains to be seen whether 2008 will show a sharp increase in actions with the credit crunch biting hard. In the meantime, individuals and entities need to be aware of the potential for disputes as parties seek to ensure that they minimise their exposure to the credit crunch and/or recoup their losses. The 'Madoff fraud' will be a prime example where the victims will be closely analysing their rights and desparately looking for some party from whom to recuperate their losses - will the SEC be in the firing line? It is pretty clear the SEC will be on some victims' shortlist.

In conclusion, the general principle still endures: where large losses are suffered, litigation usually follows.

Contacts

The information in this newsletter is for general guidance only and is not intended to be a substitute for specific legal advice. If you would like any further information please contact:


Colin Joseph
Partner, Commercial Litigation - London
t: +44 (0) 20 7556 4434
e: CJoseph@eapdlaw.com


James Maton
Partner, Commercial Litigation - London
t: +44 (0) 20 7556 4547
e: JMaton@eapdlaw.com


Antonio Suarez-Martinez
Associate, Commercial Litigation - London
t: +44 (0) 20 7556 4526
e: ASuarezMartinez@eapdlaw.com