Contractual estoppel: re-affirmed but for how long?

Overview

The Hong Kong Court of First Instance has side-stepped and yet re-affirmed the doctrine of contractual estoppel in Hong Kong in a recent judgment against the Bank of Singapore in favour of its elderly private banking customers.

The judgment offers some clear lessons for banks offering private banking services.  In particular it reinforces the need for banks to: 

1. Use clear and precise language in both customer agreements and marketing materials when seeking to define or describe the nature and scope of the customer relationship as “advisory” or “non-advisory” and “execution only”.
2. Maintain full and accurate records of information provided to customers by relationship managers about the risks associated with products offered to them.

The Court held that an advisory relationship existed between the bank and its customers here, and concluded that the relationship manager failed to adequately advise the customers of the risks associated with certain investment products.  The products were complex and classified as high risk, whereas the customers were assessed as having only a moderate tolerance for risk, and sought returns slightly better than those available from bank deposits.

Although the Court re-affirmed the existence of the doctrine of contractual estoppel in principle it did not apply it here on the facts due to the existence of the advisory relationship.  Perhaps of greater interest however was the way in which the Court recorded its consideration of the argument on the subject, which hinted towards a nascent view that the merits of the doctrine could well warrant reconsideration by an appellate Court in the future.

These comments, when taken together with the SFC’s new restriction on the inclusion of non-reliance clauses in client agreements from June 2017, suggests that the future of contractual estoppel in Hong Kong is far from certain.

Background

The claimants were an elderly couple who came into money late in life.  They did so through family connections.  After receiving an introduction to a relationship manager at the defendant bank the claimants opened several private banking accounts.  The claimants had limited knowledge of the financial markets.  They were classified as having a moderate risk appetite and sought to invest so as to exceed the rate of interest earned on bank deposits whilst preserving their capital.  The claimants were 90 and 80 years old at the time of the trial.

The products sold to the claimants over the course of their relationship with the defendant bank included:

1. Equity linked notes, including “bull notes”, “quanto range accrual notes”, “wedding cake notes”, notes with multiple underlying stocks, “renewable opportunity certificates with accruals” and “benchmark index participation securities”.
2. Foreign currency options and accumulative forwards, including “vanilla”, “knock-out”, and “knock-in-knock-out” varieties”.
3. Knock-out daily accumulators.
4. Foreign currency loans.
5. High yield bonds.
6. Equity options.

The bank’s own materials on the above products described them as “high risk investments”.

Need to create and maintain clear records of advice and customer information

In a story that will be very familiar to banking lawyers and relationship managers alike, the claimants’ investments declined in value following the financial crisis, which in turn gave rise to these proceedings against the defendant bank.

The Court held that the customers relied on the relationship manager, and that they did not understand the products or the risks associated with them.  In holding that the relationship manager had failed to give the claimants any proper explanation of the risks and disadvantages of the products, the Court of First Instance made the following observation:

“The Bank had not adduced any document or telephone recording to support its case that the risks of the investment products were adequately explained to Mr or Mrs Chang [the claimants].  What the Bank adduced was a set of product brochures dated February 2007.  However, the brochures gave no indication as to the degree or risk involved in each product (whether high, medium, or low), as opposed to the type of risks which may be involved.  Mr and Mrs Chang did not recall receiving the brochures.  Even if they had seen and read them, it is most unlikely that they would have understood the highly complex explanations given in the brochures…The contract notes sent to the Changs were highly technical.”

Although other factors (such as weaknesses and inconsistencies in the evidence given by the bank’s primary witness of fact under cross examination) clearly influenced the Court’s decision, the above quote should serve as a timely reminder for banks operating in the private banking market of the need to both:

1. Draft descriptions of financial products, and any advice concerning the risks associated with them, using clear, plain, and accurate language, and 
2. Maintain and preserve a comprehensive record of all such information given to customers, and to take particular care to do so when dealing with unsophisticated customers and anything other than low risk products.

The Court was also highly critical significant inaccuracies in bank’s record of the customer’s investment experience and financial knowledge, the files for which had been created by the relationship manager:

“One instance is the bio-data form for Mr Chang dated October 2004 that stated that he was “one of the pioneers of the famous Shiu Wing Steel Ltd, and worked together with Mr Pong Ding Yuan, founder of the steel company for years”.  As even Mrs Li [the relationship manager and primary fact witness for the bank] was forced to concede, this was a gross exaggeration of his role…Mr Chang was only a nominal director of Shiu Wing Steel and never participated in management.  Mr Chang’s bio-data form also stated that he had prior investment experience in “foreign exchange margin trading” and “futures/options”.  This was manifestly untrue.”

The inaccuracies in the bank’s records, although not determinative, clearly undermined the credibility of the bank’s primary fact witness, and with it, the bank’s ability to defend the claim.  The above paragraph is a salient reminder of the need to ensure that relationship managers take the time to properly understand their customers’ backgrounds and to accurately record that information on their file, and wherever possible, to ask the customers to verify the accuracy of the information.

Execution only or an advisory relationship?

Helpfully for banks and other financial institutions operating in Hong Kong, the Court re-affirmed the existence of the principle of contractual estoppel, notwithstanding the criticism of the doctrine from counsel for the claimants.  Less helpfully for the defendant in this case, the Court decided not to apply the doctrine here as the terms of the contract created an advisory relationship which, on the evidence, it had breached.

It was the bank’s case that at all material times the relationship manager’s responsibilities were principally to communicate with the claimants regarding the operation of their accounts, to identify products of potential interest, and to arrange execution of transactions which they would authorise from time-to-time.  The bank argued that the provision of information in this way did not constitute the giving of investment advice for which the bank could be held liable.  The bank also relied on contractual estoppel, which it said arose from the terms of its agreement with the claimants and the applicable risk disclosure statements.

In concluding that there was an advisory relationship (and that therefore it did not need to consider contractual estoppel) the Court undertook a detailed examination of the language used in the various documents which comprised the contract between the bank and its customers.  In particular the Court relied on the following clause (which it described as the primary clause governing the relationship) in holding that there was an advisory relationship:

“If you request investment Services, the Bank will purchase, sell and hold investments for your Account(s) and provide other Services incidental to this activity as set forth in this Agreement.  Investments will be as directed by you in the case of custody Accounts (Custody Accounts) and Accounts which are established on an advisory basis only (Non-Discretionary Accounts).  In the case of Accounts established on a discretionary basis (Discretionary Account(s)), investments will be as determined by the Bank in accordance with considerations of availability and applicable fiduciary standards.”

The Court viewed the underlined text above as suggesting that some advisory services were to be provided by the bank.  In construing the meaning of this clause, the Court took into account the factual matrix, and in particular, marketing materials contained in a brochure which the Court held supported the existence of an advisory relationship:

“By understanding your needs and objectives in every phase of your life, we are able to offer you solutions which best suit your personal situation.”

“Our job is not to push products.  We have an open architecture approach:  among all the products in the market, we select the best of breed products from the market to match the client’s risk reward profile.”

“Private banking is more than the combination of cash management, credits, investment advice and insurance products. It is the translation of financial questions into long-term wealth management solutions.”

“We believe that trust can only be built over time by continuously providing quality advice to our customers”.

The Court then defined the scope of the advisory duty owed by the bank to its customers here as containing three elements:

“…Mrs Li and the Bank had to exercise reasonable care and skill to ascertain the investor’s objectives and risk appetite and to have regard to these objectives and risk appetite; that Mrs Li and the Bank had to exercise reasonable care and skill to only offer products which were suitable to the investment objectives and risk appetite of the investor; and that Mrs Li and the Bank had to exercise reasonable care and skill to warn clients of the risks inherent in the investments that were being offered.”

The Court concluded that the bank failed to discharge its contractual duty of care here in that it failed to explain the risks associated with the products sold, which were inconsistent with the customers’ risk appetite.

Contractual estoppel re-affirmed, but for how long?

The silver lining for the market from this judgment is the Court’s conclusion that it would have accepted the defence of contractual estoppel had the banking relationship between the parties been “non-advisory” and “execution only”.  

The Court declined to engage in a debate on the merits of the continued application of the doctrine in Hong Kong, and instead left that particular question for the appellate courts, albeit with a slight hint that the doctrine may warrant re-consideration at some point:

“…I ought to follow persuasive English Court of Appeal authority on its validity.  If the doctrine of contractual estoppel is to be overturned then it must be done by a higher court in Hong Kong”.

Whether the Courts will continue to apply contractual estoppel in Hong Kong after the incorporation of the new paragraph 6.2(i) of the Code of Conduct into client agreements however remains to be seen.  The new paragraph 6.2(i) (which the SFC expects all intermediaries to incorporate into client agreements by 9 June 2017, if not before) reads as follows:

“If we [the intermediary] solicit the sale of or recommend any financial product to you [the client], the financial product must be reasonably suitable for you having regard to your financial situation, investment experience and investment objectives.  No other provision of this agreement or any other document we may ask you to sign and no statement we may ask you to make derogates from this clause.”

The introduction of the suitability requirement into client agreements may, rightly or wrongly, re-balance the allocation of risk between financial institutions and their customers.  Depending how it is received by the courts the amendment will go some way to undermine (or eliminate entirely) the effectiveness the typical Springwell or Peekay style non-reliance clauses so commonly seen in client agreements.  While the change will no doubt be unwelcome news for many (particularly sell-side) financial institutions, several important protections remain:

1. It is clear that the amendment does not create an advisory relationship between a financial institution and its client.  The ability to confine the scope of a financial institution’s duties by entering into execution only relationships is therefore preserved (albeit in an altered state).
2. There is nothing in the amendment which restricts the ability of financial institutions to limit the extent of their financial liability to their clients.  Such clauses are likely to receive increased focus.
3. The fact that the standard imposed by the suitability requirement is an objective one should also not be overlooked.  In assessing claims based on the suitability requirement the Courts are likely to pay close attention to documents which record clients’ financial information and objectives.  There is therefore an opportunity for financial institutions to exert some control over their litigation risk by accurately completing and frequently refreshing KYC and other client documentation.  Failure to do so could leave financial institutions needlessly exposed.

It should also be recalled that the suitability duty exists independently of any advisory relationship between a bank and its customer, and moreover, that it is essential for investments to be explained accurately, fairly, and simply.  This is particularly so in circumstances where an advisory relationship does not exist and the applicable customer agreement states that the decision whether or not to invest is exclusively that of the customer.  Failure by relationship managers to describe investments accurately and completely (especially where they are esoteric or “exotic” instruments) are likely to expose financial institutions to otherwise avoidable misrepresentation claims.

For the time being the Courts will continue to apply contractual estoppel in appropriate circumstances, but financial institutions would do well to consider whether this will remain the case long term, and to work through what implications this may have for their sales and relationship management teams and the potential risks which their activities may create.