The Ignorant Investor Taking Foolhardy Risks Test: Judicial Licence to Misuse?

The protection of high-net-worth investors from the risk of being advised to purchase unsuitable investments rarely keeps judges awake at night and suits claiming damages on such a basis often get short shrift. 

In a case heard recently in the Queen's Bench Division Justice Kerr confirmed this approach in finding that – as he read the authorities and the UK Financial Conduct Authority's Conduct of Business Rules ("COBS") – in an appropriate case, advice from a private banker may "condition" the client's risk appetite, rather than the other way round, and that there was nothing wrong with a banker using persuasive techniques to induce a client to take risks that the client would not have otherwise taken, provided that:

  • the client was able and willing to take such risks;
  • the client could afford to take such risks;
  • hindsight had not been used; and
  • the risks were not so high as to be foolhardy.

Pulling in Opposite Directions

He also noted that, while the authorities also mention the fact that the adviser sometimes is required to save the client from himself, investors must take some responsibility for their investment decisions, including mistaken ones. The duty of care must reflect a balance between those two propositions which pull in opposite directions.

Justice Kerr found that the claimants, Mr. and Mrs. O'Hare, were wealthy and intelligent, but not particularly sophisticated or experienced investors, and that their investments were relatively conservative prior to their dealings with their adviser Mr. Shone from Coutts Bank, whose persuasiveness had influenced them into taking considerably higher risks than hitherto. 

Their pre-Coutts investments had, however, been limited to plain vanilla fixed-interest products, some equities and some property dealing. Nevertheless, he specifically noted that the O'Hares could not be considered as "ignorant investors who needed saving from themselves and their own ignorance".

It is clear that given the outcome of the case, which Coutts won, in the eyes of Justice Kerr such a balance had been struck, as he found that there had been no breach of the duty of care of the banks' advisers to their customers. He found the investments the O'Hares had purchased had been suitable for them and that the losses had been caused by the subsequent performance of the instruments, not by their unsuitability. 

The Suitability Review and the 2007/8 Investments

According to Justice Kerr, "A financial adviser has a duty to exercise reasonable skill and care when advising a client on making investments. In this case, the main issue is whether that duty was breached in the case of five investments made by the claimants (Mr. and Mrs. O'Hare, or the O'Hares) on the advice of the defendant (Coutts) in 2007, 2008 and 2010." The investments at issue in 2007 and 2008 have, however, been the subject of a Coutts suitability review

The first investment that Coutts pitched to the O'Hares in 2001 was Orbita Capital Return ("OCR"), which was the first of several fund of hedge funds structured as an open-ended mutual fund that they had launched in July 1998. 

OCR purported to offer exposure to a diversified range of fixed-income, equity and related derivative products, while outsourcing the stock selection within various asset classes to external fund managers but retaining the investment profiling, portfolio construction and asset allocation process. 

A fund of hedge funds is an investment vehicle whose portfolio consists of shares in a number of hedge funds. It holds a portfolio of other investment funds instead of investing directly in securities. Open-ended mutual funds do not have a limit as to how many shares they can issue. 

At that time there was considerable debate about the issue as to whether such risky and leveraged investments were suitable for even high-net-worth retail investors, as discussed here

They were persuaded to invest $3 million in this product, of which Coutts lent $2 million. Justice Kerr also noted that Mr. O'Hare had not known until he had met Shone that banks would lend money to customers to enable the customer to invest more, or to "leverage" the investment. By doing this, Coutts was adding leverage to an investment which, like most hedge funds, was already leveraged.

The bank's position was that a client who normally held cash deposits and bonds would not, in general, be attracted to hedge funds and might not be offered any of their funds of hedge funds, although clients who were used to investing in "stocks" would be offered all of their hedge fund offerings. Coutts took the view that what Justice Kerr (at para, 61) referred to as "dabbling" in equities on the part of the O'Hares was deemed sufficient.

The Offshore Investment Bond Structure

Over the next few years, the O'Hares were persuaded to invest in, inter alia, a Clerical Medical International ("CMI") offshore investment bond which provided that 5 percent of the amount invested in could be withdrawn each year without incurring any UK tax liability, apart from basic rate income tax. 

Coutts' selling of some other investment bonds has featured in a Financial Services Authority ("FSA") mystery shopping review (referred to on p. 342 of the Royal Bank of Scotland 2015 Annual Report)

The mis-selling of investment bonds by Coutts was also addressed in an FSA final notice in 2011. 

The same investment bonds also featured in a mis-selling case brought in the Court of Appeal discussed here and here

Unusually, the claimant won damages in this case, but the facts were quite unusual in that the claimant had been seeking to invest the proceeds of the sale of his primary residence to provide a temporary tax-efficient source of income to pay rent on a property while a new property was being found. There was no question in this case that the investor had been quite willing to be persuaded to take on a high-risk investment. 

The CMI Bond and the Coutts Suitability Review

The CMI bonds had featured in a mis-selling allegation in Hong Kong and investment bonds were also included in the Coutts suitability review

Such products are complex and consist of various types of assets held in a selection of funds. They also include an element of life insurance designed to take advantage of a tax break whereby any gains on the policy could be "rolled up" and deferred until the policy comes to an end and where 5 percent can be withdrawn annually as income, with tax payable at the basic rate as noted above.

They therefore involve difficult aspects of insurance law, tax law and the law relating to collective investment schemes. It is unlikely that such products could be "understood" in any meaningful way by anyone who lacked expertise in any of these areas of law. Knowledge of how a normal fixed-interest "bond" works in theory would be of little help in understanding investment bonds. They were also a source of concern to regulators given the high level of commission that was generally available for sellers of such products in the days before the Retail Distribution Review. 

On or about 9 August 2007 Coutts recommended that the O'Hares should allocate $6 million to the high-risk dollar version of OCR held via the CMI bond and $4 million into high-risk Novus Global Credit Opportunities ("NGCO"), also via the CMI bond. 

Justice Kerr said this was a high-risk investment: "This investment in various credit markets was classed as wealth generation, or high risk. The product was described in a written product summary, which stated that it was new and had no track record; that the capital invested was spread across a portfolio of hedge funds and was not protected against loss; that it could take about seven months to exit the investment; and that it would not be suitable for someone not prepared to risk losing the capital or unfamiliar with the risks of investing in credit markets." 

The investments finally chosen were:

  • £4 million invested in NGCO;  
  • £2.125 million invested in Novus Natural Resources Strategy ("NNRS"); and
  • £2 million invested in Novus Global Emerging Markets ("NGEM").

Inappropriate Investments and the Subsequent De-Risking 

This amount of hedge fund investment (60 percent) was subsequently described in a note from a later Coutts adviser, Mr. Eugeni, as "inappropriate" (at para. 130 of the judgment) and the portfolio was subsequently "de-risked" with the hedge funds being replaced in the CMI bond with RBS structured deposits called "Autopilot" and "Navigator".

The Autopilot structured deposit was linked to the performance of an RBS constructed index called the Autopilot index. Its specification can be found at varying levels of technical detail; herehere (at p. 143) and here. This is a complex product but it is capital-protected (subject to counterparty risk.) 

Justice Kerr noted that RBS product literature concerning both the Autopilot and Navigator products misrepresented some information about the products' "past performance", citing "misleading written product information issued by RBSI, which used the heading 'Past Performance' for a product that had never performed, and the sub-headings '6 Year History of the RBS UK Navigator Index' and '10 Year History of Autopilot' to describe products that had no history. 

He further commented that the revelation that the 'history' was "simulated using actual historic market prices" was "relegated to a footnote in such small print" that he inferred that "RBSI would not mind it being overlooked". This had, however, been explained orally in discussions between the O'Hares and their adviser but Mr. O'Hare subsequently claimed not to have understood the implications of the explanation. 

A similarly misleading reference to past performance with reference to an Autopilot product can be found in here (at p. 8).

Structured Products Under Scrutiny

Which, the consumer magazine, published a critical report on structured deposits, and the FSA issued guidance on the subject of structured retail products in general in 2012. The FCA followed up with a thematic review of product development and governance in 2015. 

In addition, the FCA has taken action in cases involving such products, notably in the enforcement actions taken against Credit Suisse International and the Yorkshire Building Society for failings in the promotion of a series of capital-protected structured products aimed at non-advised retail investors. These cases are discussed in some detail. 

In a recent case in the county court an adviser was found liable for mis-selling a structured deposits product. 

In the adviser's appeal against being found liable at first instance the appeal court found that the district judge had decided that, had the retail customer been advised about the risks involved with the "bond", he would have put his money in a conventional deposit account instead. This was because he had known that the client had a limited understanding of investments and was conservative in his aims. 

The district judge had not dealt with the issue of whether there had been a breach of the obligation to ensure suitability of the product. The only finding of breach (which was upheld) was a breach of the obligation to take reasonable care to ensure that the customer understood the nature of the risks involved.

MiFID II and Structured Deposits

As was recognised in Recital 39 of the Markets in Financial Instruments Directive (MiFID) II structured deposits have emerged as a form of investment product. In contrast to other structured products, they are not covered under any legislative act for the protection of investors at Europe Union level. 

Article 1(4) of MiFID II, which will come into effect in January 2018, provides that the conflicts of interest, investor protection and organisational requirements will be applicable to structured deposits. This will include requirements on product design, disclosure, inducements, staff remuneration, non-advised sales of complex products and suitability of advice. 

Past Performance Outlawed in PRIIPS Key Information Documents

Furthermore, the FCA noted in its thematic review on structured products (TR 15/2) that the EU Packaged Retail and Insurance-Based Investment Products Regulation ("PRIIPS") will require manufacturers of investment products, including structured deposits, to provide for retail investors a Key Information Document ("KID") summarising the main features and risk. 

The PRIIPS Regulation will be directly applicable from 31 December 2016 although agreement has yet to be reached with regard to level two provisions and the European Council has proposed a delay to the implementation of Level 1 for one year. Explicit reference to past performance material has however been outlawed. 

Notwithstanding the problems that have been addressed concerning the suitability of such complex investments for retail investors, the court found for Coutts in the case of the O'Hares. The more wealthy the client, the less likely they are to win such a claim given the fact that they do have resources and can seek their own independent advice on investment decisions.

Nevertheless, the fact at that the court was happy to conclude that it was acceptable for an adviser to "condition" the risk appetite of a client and encourage him to take more risks that was his wont does appear to be at odds with the approach of the FCA, which has never engaged with the notion of "conditioning" or "managing" a client's appetite for risk. For example, in this context the FCA in its thematic review of wealth management firms and private banks demonstrated a consistent concern that the client's attitude to risk should be "explored", "assessed", "reflected", "met" or "matched." 

Furthermore, as an example of bad practice it cites a case where: "The information on one customer's file confirmed that she could not sustain any loss of income and capital. The firm wrote to her requesting that she reconsider and subsequently increased her risk appetite and the risk of her investment portfolio accordingly. It was unclear why the firm persisted in this way and this may have resulted in an unsuitable portfolio."

The "Ignorant Investor Taking Foolhardy Risks" Test

This regulatory guidance is quite at odds with some of the practices engaged in by Coutts. In one instance according to Justice Kerr, "During the discussions leading to the investment in the CMI bond, it is reasonable to infer that Mr. Shone was influencing Mr. O'Hare in the direction of accepting a higher proportion of equity investments and thereby a higher level of risk, than that with which Mr. O'Hare, with his overall 'cautious' attitude to risk, was comfortable." 

It would appear from this judgment that a wealthy client will be unlikely to succeed in an action against an adviser if he has been persuaded to have his risk appetite "managed" upwards unless he is found by the court to be "ignorant" and to have been advised to take "foolhardy" risks.

Jurisdictions: 

Helen Parry is a regulatory intelligence expert in the Enterprise Risk Management division of Thomson Reuters Regulatory Intelligence in London.