Morgan Stanley UK Group v Puglisi Cosentino [QBD (Comm)]
| Jurisdiction | England & Wales |
| Judge | Longmore J. |
| Judgment Date | 29 January 1998 |
| Date | 29 January 1998 |
| Court | Queen's Bench Division (Commercial Court) |
Queen's Bench Division (Commercial Court).
Longmore J.
Iain Milligan QC and Andrew Baker (instructed by Linklaters & Paines) for the plaintiff.
Barbara Dohmann QC and Catherine Gibaud (instructed by Middleton Potts) for the defendant.
The following cases were referred to in the judgment:
City Index Ltd v LeslieELR [1992] 1 QB 98.
Securities and Investments Board v Pantell SAELR [1993] Ch 256.
Financial services — Principal exchange rate linked security (PERLS) — Whether PERLS transaction with private customer was off-exchange margined transaction in derivative instrument — Whether bank was in breach of conduct of business rules — Financial Services Act 1986, s. 62(1); Sch. 1, para. 9.
This was an action by a bank seeking to recover from an investor losses sustained on an investment known as a principal exchange rate linked security (PERLS).
The defendant, P, in 1991 entered into a PERLS investment with the plaintiff bank. The PERLS was a currency exchange investment which depended on softer currencies holding their value or only depreciating slightly against harder currencies and was therefore a bet against the market. The PERLS consisted of a fixed interest US$ bond whose redemption value would exceed the principal amount if the hard currencies depreciated and would be less than the principal amount if they appreciated. As offered by the plaintiff bank the bonds were leveraged in two ways: first, the redemption value of the first PERLS acquired by P was expressed as being the original US$ amount plus twice the spot exchange at maturity of the Italian lira against the dollar less twice the spot exchange of the Swiss franc against the dollar, thus doubling any loss. The doubling effect could also be achieved in a different way by using two hard and two soft currencies. Second, the bank provided 90 per cent of the finance by way of loan: P invested $1m and the bank lent $9m; P bought the investment and sold it back to the bank subject to an obligation to repurchase it (a “repo”) three or six months in the future. The expectation was that the bank would roll over the investment and loan at each repurchase date, but there was no obligation on the bank to do so, and when in September 1992 the Italian lira and Spanish peseta were devalued the bank declined to roll over the investment when the time for repurchase arrived. P did not repurchase the PERLS. The bank sold it at a considerable loss and claimed that amount ($6.6m) from P as damages for breach of contract. P claimed damages (in at least that amount) under s. 62(1) of the Financial Services Act 1986 for breaches by the bank of the rules of the Securities Association (TSA). It was common ground that the bank's notice to P to treat him as a business customer/expert investor did not apply to the PERLS investments.
Held, dismissing the bank's claim:
1. The PERLS were margined transactions in a derivative instrument under r. 980.01 and 1080.01 of the TSA rules and the bank should therefore not have advised P to enter into them as a private customer and was in breach of r. 980.01. The PERLS were contracts for differences within para. 9 of Sch. 1 to the Financial Services Act 1986 rather than conventional bonds. They were therefore derivative instruments under r. 1300.02 of the TSA rules, not being excluded under that rule as “currency swaps” or “repos or similar investments” or contracts for differences under which payments were “linked to an index or other factor”. A bond with payments linked to an exchange rate might well be within the exception but the PERLS payments were to be made by reference to different exchange rates. The PERLS were margined transactions: P had provided margin because the PERLS which he had bought with borrowed money and sold to the bank under a repurchase obligation was effectively security deposited by P to cover the risk of loss on the transaction.
2. The bank was in breach of r. 730 of the TSA rules because the PERLS were not a suitable investment for P; and in breach of r. 960 in not giving an appropriate risk warning for contracts for differences. In relation to those rules the bank was in breach of statutory duty. P had showed in relation to r. 730 that he relied on the advice given. He did not have to go further and show what he would have done if he had received the correct advice. If he had received proper advice, he would in fact not have invested in PERLS. That was sufficient to provide a defence to the bank's claim. Similar principles applied to breach of r. 960. P did not have to show what he would have done if he had been given a risk warning that was appropriate. But if he did, he would not have invested in PERLS.
3. It was not necessary to give a warning of unusual risks probably arising under r. 740 in relation to the risk of the bank deciding not to roll over the borrowing used to finance the investment. The circumstances in which the bank declined to roll over the borrowing were exceptional and it could not be said that at the time P made any of his PERLS investments the risk of repurchase without any continuation of the loan from the bank was something that would “probably” arise. There was no evidence of undue pressure or influence on P to purchase the PERLS contrary to r. 640.
Longmore J:
Shortly before 16 September 1992 both the Italian lira and the Spanish peseta were devalued; on that day the pound sterling left the Exchange Rate Mechanism. Any financial investor who had engaged in speculation on the basis that these comparatively weak currencies would hold their value against stronger currencies such as the Swiss franc or the Japanese yen became liable to suffer substantial losses, and many people lost considerable sums of money. This action revolves round an investment known as a PERLS or, to give it its full name, a principal exchange rate linked security the purpose of which was to offer to investors a currency exchange investment which depended on softer currencies holding their value or only marginally depreciating against harder (or stronger) currencies. In essence it was a bet against the market but there was some intricacy about the structure of the investment.
The parties to this action are Morgan Stanley International (now known as Morgan Stanley UK Group (“Morgan Stanley”)) and one of their clients, an Italian gentleman, Mr Alfio Puglisi Cosentino (“Mr Puglisi”). Mr Puglisi was a wealthy man with money to invest. His first contact with Morgan Stanley was at the end of 1989 or beginning of 1990. As time went by Mr Puglisi was happy to undertake investments of a speculative nature in foreign exchange transactions. Eventually in 1991 he authorised an investment in PERLS; this was a structured investment put together and marketed by Morgan Stanley who, according to the expert evidence, were at this time ahead of their rivals in the field. The form of the PERLS was that it was a US$ denominated bond issued by a corporation or government agency; the redemption value of the bond was payable in US dollars but was to be calculated by reference to a formula based on a short position in one or more hard currencies and a long position in one or more soft currencies, the positions being equal at the time of issue of the bond. It amounted to what was called during the trial a “contrarian bet”, viz. a bet or speculation contrary to the wisdom of the market; this wisdom was that in normal circumstances soft currencies would get softer and harder currencies would get harder. Various features of the PERLS are important:
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(1) The bond carried interest at a fixed rate; this interest (or, as it was archaically called, “coupon”) was high in relation to a conventional US$ bond partly because the bet was contrary to the conventional wisdom of the market.
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(2) The redemption value of the bond would exceed the principal $ amount if the hard currencies had depreciated relative to the soft currencies during the life of the PERLS (in other words, if the currencies had converged), whereas the redemption value would be less than the principal $ amount if the hard currencies had appreciated relative to the soft currencies (in other words, if the currencies had diverged); in the latter event, the comparatively high coupon would afford some cushion in respect of the lower redemption value.
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(3) The redemption value of the bond could never be negative, however much the currencies had diverged; this was by reason of an express term in the bonds which the experts called “the embedded option” but which might more accurately be called “the embedded proviso” since the term to this effect was introduced by the word “provided”.
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(4) As offered by Morgan Stanley, the bonds were subject to leveraging; this took two forms; first, there was inherent leveraging in that the first PERLS acquired by Mr Puglisi (the GECC PERLS) provided that the redemption value was expressed as being the original US $ amount plus twice the spot exchange at maturity of the Italian lira against the US dollar less twice the spot exchange of the Swiss franc against the US dollar. If therefore the conventional view of currency movement prevailed (as opposed to the contrarian bet view), the loss in principal would be twice what it would have been without the inherent leverage. In formulaic terms the redemption value of the GECC PERLS was expressed as follows:
(the fraction figures being the equivalent of $120,000 at exchange rates prevailing at date of issue).
This doubling effect could be achieved in another way by, for example, taking two separate soft currencies (such as the lira and peseta) and two separate hard currencies (such as the Swiss franc and the Japanese yen). This was done for the successor PERLS investment which has been called the FEK PERLS; a third PERLS, known as the SEK PERLS, was a variation on the same theme.
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(5) The second form of leveraging was...
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