In the first of a two-part series, we look at whether the allegations against US companies such as Merrill Lynch, regarding misleading investment advice and conflict of interest, could travel across the Atlantic to the UK
If recent press reports are anything to go by, Merrill Lynch and other investment banks should be concerned. Notwithstanding the fallout from the recent 10-month investigation conducted by New York's Attorney General, it has been reported in the press that a US class action has been filed in New York against Merrill Lynch claiming a research analyst manipulated research coverage of the dot.com market to attract investment clients.
The press have also reported the possibility of criminal charges being faced by certain individuals. Despite Merrill Lynch's agreement in principle to pay a fine of $100m and institute a series of internal reforms on a no admission of guilt basis, it is estimated by the claimant's lawyers that the floodgates for litigation have now opened.
Merrill Lynch is not the only investment bank that has recently come under close scrutiny. Credit Suisse First Boston is reported to have paid $100m last year to settle claims concerning the flotation of internet businesses, and the other big players, including JP Morgan, Salomon Smith Barney, Goldman Sachs, Morgan Stanley and Citigroup, are all reported to be facing investigations. The accusations were swift to cross the Atlantic to the UK. The UK's financial industry's regulator, the FSA, is reported to be conducting its own enquiries particularly with reference to the circumstances leading up to the bursting of the dot.com bubble and the role played by financial advisers.
In this two-part article, I will consider the central reported allegations to ascertain whether claims may arise within the UK. No view is put forward as to the sustainability (or otherwise) of the reported allegations. In this part, both the problem and the potential claims against financial advisers are analysed. In part two, the possible defences are considered together with a view on where the industry is heading.
In summary, investment banks tend to be roughly split into two main divisions. On the one side is the broking arm, which employs research analysts who select shares to trade on behalf of their investor clients; on the other side, the corporate finance arm advises companies on the restructuring and raising of capital, which is sometimes achieved by issuing shares.
The current allegations concern an inherent conflict of interest where analysts on the broking arm are accused of puffing-up shares sold via the corporate finance arm in order to the win that side of the bank's lucrative fees. The analysts' salaries and bonuses were reportedly tied to how their efforts helped to maintain the flow of business to the corporate finance arm. This problem was of less concern when markets were buoyant.
Investment banks are supposed to maintain reliable Chinese walls to avoid conflicts arising. However, it is alleged that these have proved to be ineffective and investors are now looking to the banks for compensation for their losses when the artificially inflated dot.com bubble burst.
UK investors are, in part, protected by the Financial Services Act 1986 as superseded on 1 December 2001 by the Financial Services and Markets Act 2000 (the FSMA). The FSMA is the foundation for a statutory protective regime aimed at protecting UK investors from substandard investment advice. If it can be shown that the investors' needs were not put first by the bank (or other financial adviser), then the investors may have substantial claims against their financial adviser for losses incurred when the dot.com dream turned into a nightmare.
The status of the recipient of the investment advice is important, as a private person who obtains investment advice receives more protection under the FSMA than a sophisticated (usually corporate) investor. While the sophisticated investor's options for compensation under the FSMA are limited, a claim can still be brought against the financial adviser, for example, if the advice received is shown to be negligent, particularly if bad faith can be proved.
Over recent years, the English courts have increasingly been asked to consider claims where financial advisers, such as investment banks, have provided poor advice to an investor. As a result, there is an increasingly wide variety of obligations and duties imposed upon financial advisers.
Some of these are set out within the FSA's handbook and they include: the adviser acting with integrity, due skill, care and diligence; adequate management control; paying due regard and treating customer's interests fairly; communicating with the customer in a way that is clear, fair and not misleading; managing conflicts of interest fairly and maintaining the relationship of trust with the customer. In the present case, if the reported allegations are proven at court to be correct then most, if not all, of the above will have been breached.
A summary is set out below of the possible claims an investor might bring against a defendant financial adviser. The appropriate basis for a claim will depend upon the facts of the particular case.
Breach of contract
Subject to the terms of the contract, such a claim may arise from a breach of an implied and/or express obligation of reasonable skill and care owed by the financial adviser to the investor. What is reasonable advice can be compared with reference to the regulatory obligations (FSA handbook and FMSA). Even if the regulatory obligations have not been breached, they could themselves be held to be unreasonable and a claim may still be successful.
Breach of statutory duty
Section 150 of the FSMA provides a private investor with the basis for a claim against a financial adviser where there has been a breach of the FMSA (for example a contravention of the rules made by the FSA as to investment business advice). There are similar rights under section 62 of the FSA 1986 for pre-FSMA claims. Such a claim may not be brought by a sophisticated investor, however. Issues such as the suitability of the investment to the particular investor together with the investor's understanding of the risks are of relevance to most of the possible claims.
In the absence of any contractual relationship, if the investor can show that the financial adviser owed the investor a duty of care, this duty was subsequently breached (in that substandard investment advice was provided) and, as a consequence, the investor suffered financial loss, a claim may be successful.
Even if the financial loss is nominal, an investor who has suffered as a result of a financial adviser's substandard advice can make a complaint to the regulator, who has the power to impose sanctions including fines, the removal of authorisation and also compensation of up to £100,000.
Breach of fiduciary duty
This duty is generally owed by the professional financial adviser to the investor client. It is not relevant to execution only clients (those who expressly decide not to receive investment advice). This duty may be breached, for example, where there is a real possibility of a conflict of interest and/or where a profit has been made at the expense of the investor. If successful, then a claimant may also be able to recover compound interest (as opposed to simple interest as with most other claims).
Claim for misrepresentation
In almost every case where the financial adviser recommends an investment as being suitable for an investor, the recommendation contains the following implicit and/or explicit representations:
l The investment has been properly assessed by the financial adviser
l The investor's requirements have been properly assessed by the financial adviser
l Viewed objectively, the investment advice meets those requirements.
If any of the above representations are incorrect, there might be a claim for the losses resulting from the misrepresentation. If the representation (investment advice) is shown to be false, then the burden of proof is placed on financial advisers to demonstrate they thought that the representation was true. The difference between bringing a claim under the Misrepresentation Act 1967 as opposed to, say, for breach of contract and/or in negligence is that the investor claimant will not need to prove a duty of care and any contributory negligence or failure to mitigate loss is ignored when calculating the amount of the claim.
Given the reported allegations, it might be possible to maintain a claim the investment adviser made fraudulent misrepresentations and was deceitful about the nature of the proposed investments. For such a claim to be sustainable, there must be reasonable credible material establishing a prima facie case. If such a claim is successful, then exemplary (enhanced) damages may be recoverable.
Suing the adviser personally
Where the investor is particularly upset by the advice and/or conduct of a financial adviser, then a personal claim might be considered against that adviser. In the recent case of Merrett v. Babb , the employed adviser was held to be personally liable on a claim concerning negligent advice (as his employer had become insolvent).
That said, in most circumstances the employer will be the defendant as it is most likely to be insured and therefore able to pay out on a successful claim. In any event, the employer will usually provide an indemnity to the employee if such a personal claim were to be brought.
Loss of chance
A more substantial claim might be brought for the investor's loss of profit if that money would have been invested elsewhere in a safer, more lucrative investment had substandard advice not been provided. However, this loss of chance to secure a profit elsewhere must be real and substantial as opposed to merely speculative.
Suing the regulator
If an investor is feeling particularly litigious, then he or she might consider a claim against the financial adviser's regulator for poor regulatory management or for misfeasance in public office. However, due to section 1(3) of schedule 1(19) of FSMA, the regulator enjoys limited liability in damages. There is also an unresolved argument as to whether or not the regulator owes the particular investor a duty of care. That said, if an investor is unhappy with a regulator's determination then a claim can be brought to set the decision aside by the Judicial Review process.
Alexander Fox is a senior solicitor in Manches' Banking and Insolvency Group