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Is There Any Protection for the Sophisticated Investor?

Whilst the term “sophisticated investor” is not a term of art, it is certainly becoming the kiss of death. In yet another recent case (Arrowhead Capital Finance Ltd (in Liquidation) v  KPMG LLP [2012] EWHC 1801 (Comm) the courts have struck down a claim for professional negligence by a “sophisticated investor”. In this case Arrowhead was a third party which sought to claim in tort for losses arising from its alleged reliance on the involvement of KPMG as an adviser on critical aspects of  the company in which Arrowhead invested (Dragon’s) business model. 

Since this was an application to strike out certain assumptions were made about the facts. The key assumptions were that:

  1. KPMG understood fully the critical nature of the success of Dragon’s VAT repayment claims to its success.
  2. KPMG was aware that potential investors were being told by Dragon about its involvement and would be likely to rely on this as providing reassurance that Dragon’s VAT repayment claims would be successful.

When these VAT repayment claims failed Dragon’s business collapsed and Arrowhead lost its substantial investment.

Against this background the judge applied the “three part test” described by Lord Mance in Customs & Excise Commissioners v. Barclays Bank Plc [2006] UKHL 28, [2007] 1 AC 181 at [82]:

“The conceptual basis on which courts decide whether a duty of care exists in particular circumstances has been repeatedly examined. Three broad approaches have been suggested, involving consideration (a) whether there has been an assumption of responsibility, (b) whether a threefold test of foreseeability, proximity and ‘fairness, justice and reasonableness’ has been satisfied or (c) whether the alleged duty would be ‘incremental’ to previous cases.”

The judge found that the Claimant satisfied none of the limbs of the test. Most importantly, in rejecting any assumption of responsibility to Arrowhead on the part of KPMG he said [58]:

“I would accept that in some contexts the defendant’s knowledge of and consent to the fact that his advice is being passed on by his client to a third party, who will rely on it for the purpose of making an investment (using that word in a broad sense), may be sufficient to enable the third party to demonstrate sufficient foreseeability and proximity, and that the context may also show that it is fair, just and reasonable in such circumstances to impose a duty of care owed by the defendant to the third party. That is generally more likely to be the case when the third party claimant is a consumer and the context is an ordinary transaction such as the purchase of a house (as in Smith v. Bush) than in a carefully structured business context such as the present case, where the claimant was a sophisticated investor dealing with the known risk of not recovering VAT repayments as a result of the “HMCE threat”. As the cases make clear, in determining what is fair, just and reasonable, context is all important.”

How does one judge who is a “sophisticated investor”? Someone who is perfectly competent in business and capable of making sound and informed decisions about his business and investments surely should not be so categorised when faced with a complex financial product, as the recent interest rate hedging furore demonstrates. The factual context is, as the judge said, all-important.  There should be a correlation between the subject-matter of the claim and the investor’s knowledge. It is submitted that the question to be asked is whether or not the investor would reasonably be expected to know enough about the product being sold or the investment offered to understand it without a detailed explanation.

However, in the world of financial regulation it is the categorisation of the client that is important. If the loss has been suffered by a business entity in the course of carrying on any business it will not qualify as a “private person” and will not have the benefit of the statutory tort claim for breach of FSA rules under s. 150 of the Financial Services and Markets Act 2000.  It remains to be decided if the wording of s.150 prevents breaches of the rules (and, in particular, those in the Conduct of Business Sourcebook (COBS)) being relied upon as particulars of negligence in claims by any entity that does not qualify as a “private person”. It is submitted that, in the absence of express language in the statute, it does not since a claim in negligence at common law is separate and independent from the statutory tort claim even if it traverses the same ground.

A number of cases have recognised that at common law banks do not owe their clients a general duty to advise either in contract or in tort (e.g. J.P. Morgan Bank v Springwell Navigation Corp [2008] EWHC 1186 Comm ). The duty arises only if the bank or other financial institution has assumed a duty to exercise care in its dealings with the client, such as when it has tendered advice or offered an incomplete or misleading explanation of the product which it is selling (Rubenstein v HSBC Bank plc [2012] EWCA Civ 1184).

Even where contracts exist banks have been able to successfully exclude liability or to rely upon written Risk Disclosure Statements made by clients confirming that they understood the nature of the investment and the risks that they were taking, even when the client had signed the document without reading it (Peekay Intermark Ltd v ANZ Banking Group Ltd. [2006] EWCA Civ 386, [2006] 2 Lloyd’s Rep 511).

So beware the Emperor’s New Clothes syndrome. If you don’t understand the transaction, question it.
Related link:  Profile of Richard Perkoff
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