Judge sides with Barclays, and rejects claims of fraud by Cassa di Risparmio della Repubblica di San Marino A London court has deemed it fair for banks to engage in credit ratings arbitrage in the sale of complex structured credit products, setting a vital precedent for collateralised debt obligation (CDO) mis-selling cases. The judgement in a dispute between San Marino bank Cassa di Risparmio della Repubblica di San Marino (CRSM) and Barclays also sounds a warning to investors over how much responsibility they must take in risk assessment. In the March 9 ruling handed down in the commercial court, Nicholas Hamblen, a justice of the High Court of Justice of England and Wales, determined that Barclays did not make fraudulent misrepresentations in selling four sets of notes referencing CDO-squared transactions. The notes had a total nominal value of €406 million, and were sold to the San Marino bank in late 2004 and early 2005. CRSM sued for €92 million in damages, alleging Barclays deliberately obscured the true default risk in order to book a large profit. Key to CRSM’s case – the first CDO mis-selling suit in the UK based on fraud – was the contention that the true default risk was obfuscated by the AAA rating of the notes, obtained externally by Barclays in line with its pre-sale agreement with CRSM. Meanwhile, the UK bank’s internal expected loss model – designed for use in hedging and marking-to-market – assigned a 30% probability of default to the notes over the life of the trades, which would be expected of a product rated B. This, CRSM claimed, meant its investments were worth €50 million less than it paid at inception – roughly the same figure it estimates Barclays booked as profit by playing the difference between the AAA rating assigned by rating agencies and the B rating implied by its own hedging model. Barclays countered that the two ratings cannot be compared – a point the judge accepted. “Disappointingly from the perspective of buy-side claimants, the judge agreed with Barclays that the arbitrage argument was comparing two different things – with a rating you’re looking at an assessment of statistical default data, and on the other hand you’re looking at what the market is saying, which the judge accepted was comparing two different things,” says Richard East, a partner at law firm Quinn Emanuel Urquhart & Sullivan in London. The ruling went further still. If the credit spread-derived estimates of default risk are not regarded as being comparable to historically derived figures, or as providing a reliable measure of default risk, then seeking a profit from the divergence between the two was “reasonable and justifiable”, Hamblen said. This will not go unnoticed in the banking community, says Simon Clarke, a partner at London law firm Herbert Smith. “The judge found that the fact the average credit spread for the reference names in the portfolio was higher than the average for the credit rating category was a normal part of the trade and was the arbitrage the whole CDO business is based on,” he says. Barring fraud, the contractual disclaimers in sale agreements insulate selling banks, as buyers agree they fully comprehend the risks posed by the product, independent of anything the seller may tell them – known as caveat emptor, or buyer beware. To this end, the verdict has driven home the fact that English courts will respect these disclosures, particularly when a sophisticated investor is involved, says Richard Bunce, a partner at law firm Simmons & Simmons. “What is comforting for the banking community is that where sophisticated parties have entered into transactions at arm’s length, the courts will, generally speaking, respect the contractual documentation.” However, CRSM has taken issue with being depicted as a sophisticated investor, and has indicated it will approach the court of appeal. In the trial, it argued it hadn’t understood the product or the fact it could not rely on signals from Barclays as to its risk – something that lies at the heart of many of the mis-selling cases, says Dario Loiacono, a partner at Loiacono e Associati in Milan, which acted for CRSM. “We have Europe functioning with two different sets of laws in the interbank business: the UK – the most important financial market – working under caveat emptor; and the rest of Europe working under the principle of good faith,” he argues. “If you allow a bank to deliver a 40-page prospectus including untrue or misleading information, then allow them to avoid liability by inserting in the small print language saying the client accepts it has no right to rely on the information contained in it, this is against good faith.” Barclays pointed out prior to the trial that CRSM had previously invested in an earlier CDO-squared transaction arranged by Deutsche Bank. But Loiacono argues this does not prove the bank was a sophisticated investor. “The fact you once bought a similar product without understanding it does not make you an expert in that product,” he says. CRSM has until April 20 to serve notice of appeal....
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