High Court opines on COB/COBS customer classification rules

On 22 March 2011, the Commercial Court (Flaux J) handed down its judgment in the case of Bank Leumi (UK) PLC v Linda Joy Wachner [2011] EWHC 656, finding in favour of the Bank's claim for over €13million and dismissing Ms Wachner's counterclaims for negligence, misrepresentation and breach of statutory duty under s.150 of the Financial Services and Markets Act 2000 ("FSMA") for failing properly to classify her under the FSA’s former Conduct of Business Rules (COB) and the current Conduct of Business Sourcebook (COBS).

Key point of interest

The case confirms that firms only have to demonstrate they took reasonable steps under the former Conduct of Business rules (as grandfathered under MiFID) to classify customers for investment purposes, rather than meet any objective standard.  This issue - the expertise and experience of the customer for the transaction in question - is a recurring theme in mis-selling claims brought by customers against financial institutions in the English Courts.  Whilst the case also endorses the approach taken in the leading Springwell decision in relation to contractual estoppel and misrepresentation, this article focuses on the customer classification issues. 

Decision

Ms Wachner, a successful business woman, had been a customer of Bank Leumi USA ("BLUSA"), trading foreign exchange ("FX") on an execution only basis, since 2003. In 2005, Ms Wachner became a customer of Bank Leumi UK ("BLUK"), also to trade FX, and was classified by BLUK as an "intermediate customer" (rather than a "private customer"), pursuant to the FSA's Conduct of Business Rules ("COB") then in force. Ms Wachner closed her FX positions with BLUK later in 2005, however, remained a [dormant] customer of BLUK, and subsequently traded options with BLUSA via an agency agreement which allowed her access to the dealing room at BLUK.  When MiFID came into effect in 2007, Ms Wachner was automatically classified as a "professional" client under the grandfathering provisions.

Ms Wachner initially traded vanilla FX options, of which she had some experience.  She later traded "RKIs" (Reverse Knock-Ins), a slightly more complex FX option.  Her positions were transferred from BLUSA to BLUK in September 2008, when she also began trading options directly with BLUK under a €75m facility. In October 2008, BLUK closed out Ms Wachner's outstanding options under the facility when margin calls were not met, and her account showed losses of €13.4million.

Ms Wachner counterclaimed for some €20m of losses sustained on trading a large volume of options under the agency agreement, alleging various misrepresentations and negligent advice given by the Bank’s traders. Ms Wachner also argued that she ought to have been classified as a private customer/private client under the relevant COB/COBS rules, which would have prevented her from trading in RKIs, and that she was instead incorrectly classified, entitling her to bring a claim under section 150 of FSMA.

Mr Justice Flaux rejected the negligence and misrepresentation claims, affirming the reasoning in the Springwell line of cases on (a) contractual estoppel preventing the establishing of a duty of care to advise on investments and (b) the difficulty in actually establishing the firm gave advice leading to an actionable claim rather than a lesser "sales" discussion (here described by the Judge as "trading floor opinion").  He also rejected the claim for breach statutory duty, holding that the COB rules do not require a regulated firm to make an objectively correct classification, but only to take reasonable steps to classify customers, which BLUK had done in relation to the original classification of Ms Wachner as an intermediate customer in 2005. Furthermore, the Court held that Ms Wachner was not a client of BLUK in respect of trades entered into with BLUSA under the agency arrangements (and so FSMA did not apply).  Finally, the Court held that BLUK was not required to reclassify Ms Wachner in September 2008 before trading directly with her.

Analysis and Impact for Firms

Flaux J took a welcome sensible view that the former COB rules did not require a regulated firm to make an objectively correct classification, providing they took reasonable (but not exhaustive) steps to establish the appropriate classification. If that classification was appropriate under COBS, it would be appropriate when the customer classification was grandfathered under MiFID.  Any duty to reclassify under COBS (the annual review under COB having been jettisoned) would depend on the firm's actual knowledge that the client no longer fulfils the initial conditions, not what it ought to have known, provided it had exercised reasonable care.

A number of other points are noteworthy (and helpful to firms) in the judgment:

1. the classification issue is to be determined by reference to what was done and known at the time and that it is not correct to assess the classification decision based on hindsight (in this case, the subsequent run of poor trading)
2. it was acceptable for the Bank to classify in an initial letter prior to a formal classification exercise; provided the classification took place before (under the old terminology) "designated investment business" took place
3. the microscopic examination at trial of the classification exercise may reveal "cracks" or mistakes in the classification process but Flaux J doubted that would make any difference to the outcome. 

The customer tried to rely on suitability assessment failings under COBS 9 as well but these were rejected, largely because Ms Wachner was not a client of BLUK at the time of the trades in question and so COBS did not apply and because in nay event it was an execution only relationship which the Court held to be inconsistent with COBS 9.  What is interesting is the application of Flaux J's reasoning to a case where COBS 9 breaches were alleged and applicable, particularly as COBS 9.2.1 refers to firms being obliged to take reasonable steps to ensure that a personal recommendation, or a decision to trade, is suitable for its client.  It is tempting to draw the parallel given that in many mis-selling complaints, much of the debate centres on the accuracy and thoroughness of the suitability assessment and how it is documented.  The suitability failings alleged by customers often amount to the imposition of a (hindsight-coloured) objective test of suitability; although every case is fact-specific, if firms are only required to take reasonable steps (even if they get it wrong) pragmatism and realism would win the day.

Lawyers Laurence Lieberman, Richard Doble