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23 December 2014
In UBS AG (London Branch) v Kommunale Wasserwerke Leipzig GMBH ( EWHC 3615 (Comm)) the High Court dismissed claims brought by UBS AG against Kommunale Wasserwerke Leipzig (KWL), a German municipal water company, to enforce its purported right to payments owed under complex derivatives contracts issued by the bank.
Mr Justice Males in the Commercial Court dismissed UBS's claims against KWL. The judge ordered that the transactions be rescinded on the basis that – without UBS's knowledge – KWL's financial advisers had paid bribes to one of KWL's managing directors and UBS was aware that the financial advisers were acting under an undisclosed conflict of interest by seeking to advance their relationship with UBS at KWL's expense.
This update focuses on limited aspects of the judgment relevant to the issue of agency.
Between 2000 and 2005 KWL entered into four cross-border lease transactions under which it faced economic exposure in the event of a default by one or more various corporate entities. In 2006 and 2007 KWL entered into various further agreements with UBS and two other banks, Landesbank Baden-Wuerttemberg GmbH (LBBW) and Depfa Bank plc, to address their exposure to this default risk. In each case, the arrangements consisted of two primary agreements:
By themselves, the credit default swap agreements were a conventional hedge of the risk of default. However, the single tranche collateralised debt obligations were more unconventional. The economic effect of these transactions, taken together, was to exchange KWL's existing exposure to a default by any single entity for an exposure to a diversified portfolio of entities. Superficially, this diversification looked like a spreading of risk over a large number of different entities. However, in reality, the arrangement meant that if only a small proportion of the weakest entities in the portfolio were to default, it would leave KWL with a large exposure to the relevant bank counterparty.
UBS had originally planned to conclude all of these single tranche collateralised debt obligations with KWL directly but it could not obtain internal credit approval to do so. It therefore used two other banks, LBBW and Depfa, as intermediaries between it and KWL on three of the four transactions. UBS then entered into single tranche collateralised debt obligations with these banks on back-to-back terms.
The single tranche collateralised debt obligation elements of the four transactions were as follows:
In exchange for assuming this risk, KWL received a net premium for each single tranche collateralised debt obligation (after deducting the costs of the credit default swaps). However, only a modest amount of this premium was actually received by KWL. The majority of this payment was siphoned off by Value Partners, KWL's financial adviser, which in turn paid part of the sum to Mr Heininger, one of KWL's two managing directors, as a bribe to approve the transactions.
Between 2008 and 2010, following a series of credit events, significant sums became payable by KWL to UBS, LBBW and Depfa.
UBS sought to recover from KWL the sum which it claimed to be due under the UBS single tranche collateralised debt obligation following its early termination due to the credit events.
KWL resisted the claim on various grounds, including that the transaction was voidable because:
It was common ground that Heininger was paid a bribe by Value Partners to conclude the single tranche collateralised debt obligation transactions. However, it was not suggested that UBS was aware of the bribe.
The court cited The Ocean Frost,(1) which held that if an agent in the course of his or her employment or authority bribed a servant of a third party so as to induce the third party to contract with the principal, the third party would be entitled to rescind that contract.
Therefore, the relevant legal analysis centred on two issues:
In relation to the first issue, the court observed that the fact that Value Partners was the agent of KWL did not preclude a finding that it was also the agent of UBS (although the court noted that dual agency of this sort would generally put the agent in an impossible position).
The court noted that when determining whether an agency relationship existed it did not matter whether the parties themselves regarded the relationship as such. The key question was whether they had agreed to a relationship which amounted, in the eyes of the law, to an agency relationship (citing Garnac Grain Co Inc v HMF Faure & Fairclough Ltd).(2) On the facts, the court thought it was clear that between April 2006 and the conclusion of the UBS single tranche collateralised debt obligation, UBS and Value Partners did work together in order to ensure the conclusion of the transaction, regardless of KWL's interests, which the court viewed as an agency relationship. It was immaterial that the relationship was not formalised as such in contract.
In relation to the second point, the court held that the bribe paid by Value Partners was within the scope of its agency relationship with UBS. Value Partners was UBS's agent for the purpose of procuring its clients to contract with UBS and that is what it had done. The fact that it did so by means of a bribe not known to or authorised by UBS did not take its conduct outside the scope of its agency.
The court therefore concluded that UBS was responsible in law for the bribe paid to Heininger.
Conflict of interest defence
The court also considered the conflict of interest defence. It began by articulating the principle that an agent owes its principal a fiduciary duty of single-minded loyalty and that this includes avoiding conflicts of interest (Bristol & West Building Society v Mothew).(3) Where an agent has a conflict between its interest and its duty which is not disclosed to the principal, the principal is entitled to rescind any contract entered into by that agent (Logicrose Ltd v Southend United Football Club Ltd).(4)
Applying these principles to the case, the court considered that three questions arose:
The court thought it obvious that, for the same reasons which justified a finding in KWL's favour in respect of the bribery defence, the answer to first two questions was yes.
The third point was the most contentious. The relevant issue was what knowledge could be attributed to KWL (a prerequisite to consent). UBS contended that the knowledge of KWL's managing directors should be attributed to KWL, one of whom was plainly aware of the fraud (having been the recipient of it).
The court noted it was an established rule that the knowledge of a director is treated as being the knowledge of the company of which he or she is director. However, an exception – the Hampshire Land principle(5) – exists in respect of the company's knowledge of wrongdoing by the director him or herself or in which the director is complicit.
Applying this exception, the court held that Heininger's knowledge of his misconduct with Value Partners should not be attributed to KWL. Therefore, KWL could not have consented to the conflict and the court held that the conflict of interest defence should succeed.
Having succeeded in its bribery and conflict of interest defences, KWL was entitled to rescission of the UBS single tranche collateralised debt obligation. The result of this was that UBS was unable to claim the sums due from KWL under the UBS single tranche collateralised debt obligation and KWL was ordered to repay the premium received (less the bribe paid).
Claims under other single tranche collateralised debt obligations
The court held that the back-to-back single tranche collateralised debt obligations between UBS and LBBW and Depfa were rescinded on the grounds of fraudulent misrepresentation by UBS. The court also held that as a result of this recession, neither LBBW nor Depfa could enforce their respective single tranche collateralised debt obligations against KWL.
In many respects, the facts of this case are extraordinary and, as the judge stated in his concluding remarks, "a case study in how not to conduct investment banking in a fair and honest way".
KWL will be relieved that it escaped from having to pay an exorbitant sum to UBS, in part through the established laws of agency. However, KWL and other companies entering into complex derivatives with investment banks should treat this case as a cautionary tale. When entering into such contracts there is often a vast disparity in the understanding of a product between an investment bank and its would-be client. In a striking passage of cross-examination recorded in the judgment, Mr Czekalowski, the former head of the structuring team at UBS, described how difficult it is for clients to negotiate in respect of these types of product. In evidence, he stated that there were "figuratively" about 200 different ways a bank could move around value so that it was difficult for a client to make a detailed comparison.
Clients who have entered or who are considering entering such arrangements would be well advised to look carefully at the hidden risks they may be assuming and to consider the roles taken and duties owed by any intermediaries which might be involved in the structuring.
For further information on this topic please contact Simon Hart or Chris Whitehouse at RPC by telephone (+44 20 3060 6000), fax (+44 20 3060 7000) or email (firstname.lastname@example.org email@example.com). The RPC website can be accessed at www.rpc.co.uk.
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