March 2016
Recently, the Hong Kong Court of First Instance handed down its judgment in the case Li Kwok Heem John v Standard Chartered International (USA) Limited (“Bank”). The case was brought by a victim of the infamous Bernard Madoff ‘Ponzi’ scheme against Standard Chartered Bank, where he invested in the fund that was ultimately found to be a fraud. This case has sparked much debate on the obligations banks owe their investors and what measures they need to start taking to better protect themselves from liability in the event they found themselves in the midst of a Ponzi scheme.
In Part I of this Q&A, we spoke with Laracy & Co’s dispute resolution team to further examine the big lessons learned from this case, new and upcoming amended regulations bearing on the case’s issues, “suitability clauses”, and the effectiveness of a bank’s risk disclosure statements, updates and fact sheets.
In Part II, Laracy & Co.’s Dispute Resolution team takes us further into the case to look at the adequacy of due diligence by a bank and modifying risk disclosure statements to best protect a bank in the event a third party fund they it sells turns out to be fraud.
CL: On the Breach of the Duty of Care charge, the Court addressed the issue of due diligence by the Bank, and found that if the auditors and custodian bank are supposed to work according to professionally acknowledged standards or code of conduct or declared principles which are acceptable, then unless there are matters that raise concerns about their reports, the financial adviser from the Bank can safely rely on the reports without making any further enquiry.
Should this be interpreted to mean that if the due diligence that a bank follows is part of the standard industry practice, then they have no further duty to investigate a fund that it sells to customers to ensure it actually has the assets it claims to possess?
Laracy & Co: Yes, banks are generally entitled to rely on the due diligence done by third parties in accordance with professionally acknowledged standards/code of conduct/declared principles. However, where a bank has any concerns with the information provided by the third parties, it would then have an obligation to make further enquiries to respond to those concerns. Separately, the standard of due diligence required by the Bank when investigating a fund is to conduct due diligence with reasonable care and skill.
In this case, the issue was that the Court saw no evidence that the Ponzi scheme could have been discovered even if the Bank undertook more comprehensive /additional due diligence. There was no evidence to show that any failure of the Bank’s due diligence led to the client’s loss.
CL: What should banks do to ensure they are following the best due diligence practices in this regard?
L&C: Where due diligence is being done by a third party, the bank needs to ensure that the third party is a reputable, professional organisation that complies with professionally acknowledged standards. Where a Bank is undertaking its own due diligence on a fund it needs to be thorough in its initial and on-going due diligence.
In this case, the Bank undertook the following as part of its due diligence:
• Analysed the Fund’s returns by comparing them against industry benchmarks;
• Reviewed due diligence questionnaires prepared by the Fund Manager which contained information about the fund and its Fund Manager including the history, management structure, strategy and track record, and ensuring this was consistent with information provided by independent third-parties and other information discovered during their due diligence process;
• Studied 12 years of financial statements audited by PwC;
• Senior employees of the Bank had attended meetings and discussions with the investment manager; and
• Requested meetings with Mr. Madoff every 6 months, even though he rarely met with investors from feeder funds – a meeting eventually took place in April 2008.
All of this demonstrates that “best due diligence practices” requires the Bank to be thorough and proactive.
It is, also, helpful that banks have separate “product” due diligence obligations under the Code of Conduct. While these are different in the sense they focus on the “product” rather than the “fund”, there will inevitably be overlap between the two. For example, the SFC’s Q&A gives the below advice:
• The Bank should develop a thorough understanding of how the products work, including the nature of underlying investments, the level of risks they bear, the experience and reputation of the product issuer, and the relative performance and liquidity of investment products; and
• The Bank also needs to consider the market and industry risks, economic, political and regulatory environments which may impact the risk return and growth prospects of the products; and
• The Bank should make their own enquiries about the risks from the product issuers, and not rely on prospectuses, offering circulars or marketing materials.
CL: In addition, the Court opined that the risk disclosure statement did not cover low risk hedge funds, only high risk investment activities, and accordingly the Bank could not rely on the statement to avoid liability. The Court further determined that the risk disclosure statement did not satisfy the required level of reasonableness after reviewing its terms and the given circumstances.
L&C: Based on this assessment, how should banks modify their risk disclosure statements so that they meet the standards of reasonableness and adequately protect themselves.
The Judge in this case said “if need be” he would adopt the contra proferentem rule of interpretation to find the Risk Disclosure (“RD”) statements did not apply to low risk hedge funds (giving the benefit of doubt in favour of the investor who has less bargaining power).
The Judge also held the RD statements were “repugnant to the intention of the parties” as expressed in the Business Conditions which applied to custodian and investment services. The bank had used an “investment adviser” whose duty was to give advice to the Plaintiff on investments, and thus the RD statements were “contradictory to the reality,” and it was artificial for the Bank to rely on them as a defence (contractual estoppel defence).
Further, the Judge acknowledged that the RD statements might be appropriate for clients who engage in high risk investments of a highly speculative element on the basis it would be reasonable for a Bank not to assume responsibility for such high risk and volatile investments.
On reasonableness, the Judge noted the investor was experienced in investing in equities, but not funds and he could not tell which of the multitude of funds was suitable for him. To evidence this, the Judge pointed out that the investor needed advice and recommendations from the Bank through its Investment Advisers. Additionally, the terms of the RD statements sought to exclude liability from the very service that the investor needed even if provided in a negligent way and the investor had little choice and he couldn’t negotiate out of their severity or escape from them by going to another Bank as such terms were common in standard contracts. As such, the RD statements did not satisfy the requirement of reasonableness in section 3 of the Control of Exemption Clauses Ordinance and the Bank could not rely on them to exclude or restrict liability in relation to the investor’s purchase of shares in the fund.
Moving forward, banks should make it clear that the risk disclosure statements expressly relate to the financial product which is being sold by the Bank so that the Court cannot say they don’t apply to a particular product because it is not expressly mentioned. They need to make sure there is no ambiguity or scope to argue that particular products are excluded from the RD statements.
German to this issue, It is important to consider the second clause that the SFC has introduced into its Code of Conduct which is an express provision in the Code of Conduct that prohibits the inclusion of any non-reliance clauses in any client agreement or other documents. The clause states as follows:
“6.5 No inclusion of clauses which are inconsistent with the Code or which misdescribe the actual services provided to clients
• A licensed or registered person should not incorporate any clause, provision or term in the Client Agreement or in any other document signed or statement made by the client at the request of the licensed or registered person which is inconsistent with its obligations under the Code.
Note: This paragraph precludes the incorporation in the client agreement (or in any other document signed or statement made by the client) of any clause, provision or term by which a client purports to acknowledge that no reliance is placed on any recommendation made or advice given by the licensed or registered person.
• No clause, provision, term or statement should be included in any Client Agreement (or any other document signed or statement made by the client at the request of a licensed or registered person) which misdescribes the actual services to be provided to the client”
This provision will also come into effect on 9 June 2017, and breach of this clause by financial institutions will give clients a contractual claim in damages. The effect of this clause is also re-enforced by the express wording found in the suitability clause mentioned in Part I of this Q&A in that the banks cannot “derogate” from its obligations under the suitability clause i.e. banks cannot rely on non-reliance clauses to avoid liability for breach of their contractual suitability obligations.
Accordingly, disclaimers found in client agreements arguably no longer have any practical effect and may afford no protection to financial institutions. Moreover, they cannot rely on the defence of contractual estoppel. However, it remains to be seen if banks will take this extreme step and formally exclude all non-reliance clauses from client agreements, thereby deliberately exposing itself to liability.
If banks choose to continue incorporating non-reliance clauses into client agreements (which would be a breach of the Code of Conduct), it is likely that it will face sanctions from the SFC for breach of the Code of Conduct. On the other hand, the Courts may take the view that under certain circumstances it is reasonable under the Control of Exemption Clauses Ordinance to include a non-reliance clause, especially where the client is a professional and experienced investor as demonstrated by this case.
Even if the non-reliance clauses are struck down by the Court, the investor still has to prove that the Bank had breached its duty of care and was negligent. This will still be challenging, particularly, if the bank has done its own due diligence on the fund to an acceptable standard.
For further information, please contact:
Bryan O'Hare, Partner, Laracy & Co in association with Hill Dickinson Hong Kong LLP
bryano'hare@laracyco.com
Joni Wong, Laracy & Co in association with Hill Dickinson Hong Kong LLP
joniwong@laracyco.com
