Case No: 2010 Folio 1311

Neutral Citation Number: [2013] EWHC 3127 (Comm)

IN THE HIGH COURT OF JUSTICE
QUEEN'S BENCH DIVISION
COMMERCIAL COURT
Royal Courts of Justice
Strand, London, WC2A 2LL
Date: 16/10/2013
Before:
MR JUSTICE BLAIR
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Between:
FRSTA AP-FONDEN Claimant
- and -
(1) BANK OF NEW YORK MELLON SA/NV
(2) THE BANK OF NEW YORK MELLON
(FORMERLY KNOWN AS THE BANK
OF NEW YORK)
(3) BNY MELLON (FORMERLY KNOWN
AS MELLON BANK NA)
Defendants
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Mr Ali Malek QC and Ms Catherine Gibaud (instructed by Bird & Bird) for the Claimant
Mr Mark Hapgood QC and Mr Jonathan Dawid (instructed by Clyde & Co) for the
Defendants
Hearing dates: 10, 11, 12, 13, 17, 18, 19, 20, 24, 25, 26, and 27 June and 1, 2, 3, 8, 15 and 16
July 2013
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JudgmentMr Justice Blair:
1. This is a claim arising out of a form of financial activity called securities lending. The
claimant, Frsta AP-fonden (AP) is a Swedish pension fund, and brings these
proceedings against the defendant, Bank of New York Mellon (BNYM), which
managed its securities lending programme. It seeks to recover losses suffered in respect of
a holding of medium term notes (MTNs) issued by Sigma Finance Inc (Sigma).
These notes were a type of fixed income security, and Sigma was one of a kind of
financial company called Structured Investment Vehicles, or SIVs. They flourished
prior to the crisis, but disappeared during its course, giving rise to litigation as to how their
remaining assets were to be distributed. Sigma itself failed in September 2008 at the height
of the financial crisis (see Re Sigma Finance Corp [2009] UKSC 2).
2. BNYM had acquired the Sigma notes for APs account by way of investment of cash
collateral for APs securities which were loaned out. The claim is stated in various ways,
but, in essence, AP contends that BNYM was at fault in acquiring and retaining the Sigma
notes for its account, and in the way it dealt with AP after problems with Sigmas financial
standing became apparent. The claimed loss on the notes is about US$35.5m, less about
US$1.8m received from Sigmas receivers. In defence, BNYM contends that the Sigma
notes were considered good investments at the time, that the complaints are made with the
benefit of hindsight, and that the losses were the result of the crisis and not of any failings
on its part.
The parties
3. As constituted following a 2001 reorganisation, Frsta AP-fonden is one of five buffer
funds within the Swedish pension system, whose purpose is to contribute to deficits in
pension distributions caused by temporary market fluctuations and demographic
imbalances. The funds operate independently of each other. Frsta AP-fonden is called
AP1 for short, the others being AP2 and so on, but since it is the only relevant fund in
this litigation, it is referred to simply as AP.
4. AP is a relatively small organisation based in Stockholm, with about 65 employees at the
time of the inception of its relationship with BNYM in 2004. The assets of the AP fund
are public monies, paid as taxes and allocated to it from The National Social Insurance
Authority of Sweden. On 1 January 2001, it had net assets of SEK134bn (approximately
US$14bn) to manage. As at 30 June 2012, it had assets under management of SEK221bn
(approximately US$31bn) in a global portfolio consisting of equities, fixed income
securities and alternative investments that include real estate, private equity funds and
hedge funds. Approximately 40% of the fund is externally managed.
5. The Bank of New York Mellon is a financial services provider, the particular services at
issue here being those of global custodian, a term which describes an institution that holds
securities for various types of fund. It was formed on 1 July 2007 from the merger of
Mellon Bank (Mellon) based in Pittsburgh, and the Bank of New York (BoNY)
based in New York, where the merged company is now headquartered. Prior to the
merger, both Mellon and BoNY had large and active securities lending programmes.
Following the merger, the two programmes were combined resulting in the largest
securities lending operation in the world. I am told that it has over six hundred clients, US
$3 trillion of lendable assets in custody, and up to US$700 billion on loan at any given
time.
6. Prior to the merger, APs relationship was with Mellon and, specifically, with ABN
AMRO Mellon Global Securities Services B.V., which was a Netherlands-incorporated
subsidiary of Mellon Bank. The relevant officers handling APs account were based in
London and Pittsburgh, and after the merger, some of the relevant officers were based in
New York as well. The presence of the second and third defendants in the proceedings
has to do with the assumption of liabilities on the merger, and it is unnecessary to say
anything more about them.
7. To make sense of the evidence it is necessary to mention Standish Mellon (Standish),
which was a subsidiary of BNYM that provided an asset management service. It was
operationally separate from BNYMs securities lending division, with its own credit and
portfolio management functions. Whilst BNYM stresses the independence of the entities,
AP says that Standish and securities lending in effect joined forces on their Sigma
exposure and shared information. This is demonstrated by the similar terms in which
clients were written to in May 2008. AP submits that in practice they shared the same
views about Sigma. I consider that the evidence does show considerable contact between
them as regards Sigma as the crisis developed, particularly during 2008, and return to this
subject below.
Narrative framework
8. The basic facts are uncomplicated, and the following is a narrative framework. In October
2004, after a tender process, AP entered into a Global Custody Agreement with BNYM
followed by a Securities Lending Authorisation Agreement in December 2004.
9. Once the programme was in operation, BNYM provided daily reports to AP as to the
securities held in its cash reinvestment portfolio. Holdings reports could be accessed on
BNYMs online Workbench system. After the initial negotiations, there seems to have
been relatively limited direct contact, with reviews every six months to discuss how the
programme was doing. Matters appear to have operated smoothly, and APs witnesses
made it clear that it was satisfied with the service it received from BNYM.
10. Sigma was added to BNYMs approved list of issuers in August 2005. BNYM acquired
Sigma securities for APs account on five occasions, all of which went on to mature at par.
Approval was not sought for these acquisitions, nor was there any need for APs
approval, since BNYM managed the collateral investments on a discretionary basis.
11. The disputed Sigma MTNs (the ones which eventually defaulted) were acquired by
BNYM for APs account as collateral in two tranches:
(1) US$5.5m acquired on 12 March 2007 and maturing 12 March 2009; and
(2) US$30m acquired on 26 or 30 April 2007 (the date of acquisition is in dispute) and
maturing 30 October 2008.
12. Over time, there were some adjustments to the agreed terms. On 29 May 2007 AP
increased the limit on lending across its portfolios to US$10bn (which meant up to about a
third of its total assets was eligible for lending out).
13. It does not appear that the onset of the credit crunch in mid 2007 caused any particular
difficulties in the relationship between the parties. However, as its internal documents
show, BNYM became increasingly attentive to potential problems with its Sigma
securities, to which it had a large overall exposure, particularly after the 2007 merger of the
two banks.
14. Following a downgrade by the rating agencies, and a sharp reduction in the pricing of the
securities, BNYM contacted its clients (or some of them) about Sigma. There were
telephone calls between the parties on 16 May and 19 May 2008 which have been the
subject of much dispute at trial, not so much as to what was said, but as to whether
BNYM fairly represented the position.
15. Following the calls, AP tightened its investment criteria, but it continued to hold the Sigma
MTNs, because, AP says, the bank had misrepresented the position to it. It was still
holding them at the time of Sigmas default in October 2008. BNYM says, and I do not
think that this is in dispute, that the Sigma MTNs were the only investment in APs cash
collateral portfolio to default. As a result, total losses on APs cash collateral in the wake
of the crisis were under 2% of the value of its portfolio. Even taking account of these
losses, BNYM says, AP still saw a net profit from its securities lending activities with
BNYM.
Outline of APs claims and BNYMs defences
16. APs claims can be summarised succinctly. First, BNYM should not have acquired the
Sigma MTNs on its behalf. Second, having acquired them, it should not have held on to
them when the market went into crisis. Third, the approach that BNYM finally made to
AP in May 2008 about what to do with them was inadequate.
17. As set out in APs opening submissions, its three main heads of claim are put as follows:
(1) Acquisition: APs primary case is that the Sigma MTNs should never have been
acquired for the portfolio, because AP was a conservative securities lending client. In
particular, AP should never have had any exposure to investments that were (it is
alleged) illiquid. BNYM responds that AP was not particularly conservative, the
Sigma MTNs were liquid at the time of acquisition, and complied with the agreed
investment guidelines, which were the only applicable criteria.
(2) Retention: APs secondary case is that the retention of the Sigma MTNs in APs
account beyond August 2007, or, at latest January/February 2008, was outside
BNYMs authority, alternatively in breach of the agreement between them and/or
negligent. BNYM responds that market concerns over Sigma during this period
related to liquidity, not capital adequacy, and it reasonably assessed that the prices
available for Sigma MTNs in the market were unfavourable given the strength of
Sigmas portfolio and the likelihood that it would survive to repay them at or close to
par.
(3) The claim relating to communications with AP in May 2008: This was the focus of a
considerable part of APs case at trial, the case being that BNYM was negligent and/or
misrepresented the position and/or was in breach of fiduciary duty in these exchanges.
AP says that BNYM downplayed the reasons why Sigma MTNs were being priced at
a discount saying that there was no cause for concern, and that BNYM was intending
to hold the Sigma MTNs to maturity, whereas its view in fact was that there was a
significant likelihood of Sigma defaulting. BNYM responds that it properly informed
AP of its conclusion that the best course of action was to hold the Sigma MTNs to
maturity, and had no duty to pass on to AP the market information underlying this
conclusion, nor that other market participants may have had different views, nor what
other approaches it may have taken in relation to clients with different investment
requirements. Nor, it submits, did it have any duty to advise AP what course to take,
since its position was that of an investment manager, not an investment adviser.
18. AP also puts its case in breach of fiduciary duty, including a case that BNYM dealt with
the Sigma MTNs entirely (it says) on a programme basis, that is, by reference to factors
common to all of their securities lending clients, rather than by reference to what was in the
best interests of AP. BNYM responds that it owed AP no fiduciary duties, and that it was
not the size of its exposure to Sigma that caused difficulties, but rather the fact that the
unprecedented long-term seizing up of the credit markets from August 2007 meant that
any sizeable amount of Sigma MTNs was effectively unsaleable save at fire-sale prices.
19. AP also asserts that BNYM was in breach of its duties under the applicable regulations
relating to best execution.
20. BNYM also says that APs case founders by reason of BNYMs causation and
remoteness defences, and it has a claim in respect of contributory fault.
The trial
21. The proceedings were begun by AP in November 2010. The claim was subject to
substantial (and disputed) amendments in March 2013, some of which were disallowed.
22. There was a considerable body of further disclosure made by BNYM just before and
during the trial. In particular, this included transcripts of depositions together with
exhibited documents given by BNYM officers in proceedings of the US District Court for
the Eastern District of Oklahoma (Compsource Oklahoma, Board of Trustees of the
Electrical Workers Local No. 26 Pension Trust Fund and Others v BNY Mellon N.A., and
others, Case No: CIV 08469-KEW). I am told that the Oklahoma proceedings also
concerned the reinvestment of cash collateral in Sigma MTNs by BNYM for other
securities lending clients.
23. As I explain below, some of this material was relevant in the present case. It is regrettable
that this disclosure was made so late, and only after AP pressed for it, and an apology was
rightly made by BNYM. However, I reject any suggestion that documents were
deliberately suppressed. Disclosure was a major task in this case, and BNYM disclosed a
very large quantity of material. I am satisfied that this was a matter of omission.
24. The parties agreed, and observed, a timetable for the trial, which took place over some
seven commercial court weeks in June and July 2013. Cross-examination was limited in
an appropriate way following discussions between counsel and with the court at the pre-
trial review and in opening submissions (There was initially some controversy during
closing submissions as to whether the claimants case had been properly put, but this
controversy was rightly not pursued. BNYM does however maintain that minimal
attention was paid to APs acquisition claimeven if correct, this makes no difference to
my decision.)
25. As has become usual in this court, the oral openings and closings were relatively brief,
with the parties cases set out in substantial written submissions. I have considered all the
points made and re-considered the evidence referred to in them whether or not expressly
referred to in this judgment.
26. The factual witness evidence in order of testimony was as follows. For AP: (1) M s
Gun Hammarlund, who from 2000 has been APs Head of Back Office and Accounting
Department and who had responsibility for managing the custody relationship between AP
and BNYM. (2) Mr Mikael Grunditz, who from 1993 to 2009 was head of APs Risk
Management Department. (3) Mr Anders Rahmn, who has been APs Head of Business
Support and Risk Control since 2000. (4) Mr Johan Magnusson, who became Managing
Director of AP in March 2008. (5) Ms Cecilia Thomasson-Blomquist, who between
2000 and March 2009 was APs Head of Foreign Exchange and Treasury and who had
primary responsibility for the performance of APs securities lending portfolio. She
reported to APs Managing Director.
27. BNYMs factual witnesses (again in order of testimony) were: (1) Mr Brian Blanchard, at
the relevant time a Securities Lending Sales Specialist at Mellon based in Luxembourg,
who was responsible for negotiating BNYMs appointment as APs securities lending
agent. (2) Mr Larry Mannix who was based in New York and headed the reinvestment
desk. (3) Mr Tom Ford who was head of securities lending at BNYM and had overall
responsibility for the programme. Prior to the merger, he was head of securities lending at
BoNY, with Ms Kathy Rulong holding the equivalent position at Mellon. Following the
merger, Ms Rulong continued as co-head of the merged division, and succeeded Mr Ford
following his retirement on 30 June 2008. (4) Mr Bob Fort who had been in charge of
cash collateral investments at Mellon and who retained responsibility for legacy Mellon
clients, including AP. (5) Mr David Tant who headed the Credit Analyst Group, and who
was BNYMs (and formerly Mellons) Chief Reinvestment Credit Officer for Securities
Lending. (6) Ms Diane Demmler, Senior Sector Analyst, Cash Investment Strategies, who
performed the initial credit analysis of Sigma by Mellon in 2005. (7) Mr Steve Gordon
who was the Senior Relationship Manager for BNYM based in London with overall
responsibility for the client relationship with AP.
28. There were two categories of expert evidence. First, as to the nature, risk characteristics,
pricing and liquidity of the Sigma MTNs during the period from March 2007 to October
2008 including: (i) pricing information and the extent of trading on the secondary market;
and (ii) the market value of the Sigma MTNs and the effect that a sale of the Sigma MTNs
would have had on the market. On this, expert evidence was given by Mr Neil Servis for
AP and Mr John J. Richard for BNYM. They also gave evidence as to the credit
monitoring of Sigma MTNs undertaken by BNYM.
29. Second, as to market practice in relation to the typical role and duties of a securities
lending agent in the position of BNYM including how a reasonably competent securities
lending agent would have acted in the circumstances with regard to the purchase and
subsequent retention of the Sigma MTNs. On this, expert evidence was given by Mr
John Cirrito for AP and Mr Roy Zimmerhansl for BNYM.
30. There was one further category of expert evidence. BNYM adduced evidence from
Professor R. Glenn Hubbard on whether or not the collapse of Lehman Brothers in
September 2008 was foreseeable. He considered that it was not, since the market assumed
that Lehman would be rescued by the US Government, because it was (in the oft-repeated
phrase) too big to fail. The claimant did not require his attendance for cross-
examination. As I explain below, I consider that this was an appropriate decision. In any
case, I have read Professor Hubbards report.
31. Though the parties have each made certain criticisms of the factual witnesses, in my
opinion they were generally good witnesses, who gave their evidence in a professional
manner. Some further comments as regards the witnesses are set out below. Where I have
not accepted witnesses evidence, as is the case even from witnesses who I generally
considered reliable, it is because it was inconsistent with the contemporary material.
32. A specific criticism is made by AP that Mr Tom Ford (who before his retirement was joint
head of securities lending at BNYM) was only prepared to give evidence by video link
from New York for an afternoon. It is necessary to say something about this, because he
was the most senior witness called by the bank. His witness statement was supportive of
its case, but documents, including documents disclosed at the beginning of the trial,
contradicted it in certain respects. Though I should note that Mr Ford gave family as well
as business reasons for not being able to come to court to testify in person, I consider that
AP was disadvantaged by only having an attenuated opportunity to challenge testimony
from the only key BNYM decision maker who gave evidence.
33. I am satisfied that the evidence of each of the experts was of value, though I have had to
prefer one to the other on particular issues. There are two points to make at this stage.
BNYM criticises Mr Servis, saying that he was prone to give long answers, and was
highly selective and partisan. It is correct that his answers were sometimes indirect,
particularly when compared to those of Mr Richard, who has much more experience
giving evidence as an expert. However Mr Servis has substantial market experience albeit
not primarily in the securities lending field. Whilst I have often preferred the evidence of
Mr Richard, I reject the suggestion that the evidence of Mr Servis was of no value, and it
was certainly not especially partisan compared with the others.
34. Mr Zimmerhansl is presently head of securities lending at HSBC, and his was the most
direct experience of this particular field. I have given it weight accordingly. Mr Cirritos
experience was less relevant and less current, since he has been retired for some time. He
was not extensively cross-examined, it having been agreed between counsel that there was
no requirement for him to be challenged on every issue. Whilst Mr Cirritos evidence was
appreciated by the court, it does not reflect extensive experience of securities lending, as
opposed, for example, to standards to be observed in giving investment advice. Where it
differed from that of Mr Zimmerhansl, I preferred the latter, save where indicated below.
35. My findings of fact and law are set out below.
Securities lending
36. The basic structure of securities lending is not in dispute, and was well described in the
evidence. Securities lending is an established practice by which a party holding securities,
such as a pension fund, insurance company, sovereign wealth fund, or the like, lends them
out to another party, such as a bank or a hedge fund, against collateral and in return for a
lending fee. In some of BNYMs material from 2008 there is this description: Typical
clients include mutual funds and pension funds which have long security positions and
wish to enhance a yield on their funds by lending the securities in exchange for cash
collateral. The securities are typically lent to brokers who have short positions. For
present purposes, a short position arises where the borrower of the securities seeks to
profit from a fall in their price by borrowing and selling them, hoping later to buy them
back at a lower price and return them to the lender.
37. The amounts involved are substantial. As at the end of 2010, I am told that it was
estimated that some US$13 trillion of securities including equities and bonds were
available for loan. The evidence is that securities lending is currently running at about half
pre-crisis levels. Although AP still operates a securities lending programme, that
programme no longer involves the reinvestment of cash collateral, and the evidence
suggests that this may be reflective of a more cautious approach on the part of fund
holders, as well as a sharp decrease in short selling.
38. For practical reasons, securities lending is commonly performed by the lenders securities
custodian, so that loans of securities are negotiated by the same institution as directly holds
the securities. That is the case here. In 2004, BNYM was appointed as APs global
custodian, and a few months later was appointed its securities lending agent, a commercial
arrangement which suited both parties.
39. Taking collateral from the borrower is an important part of the business, not only to protect
the lender, but also to generate income. Securities loans may be made against non-cash or
cash collateral. Non-cash collateral is generally in the form of other securities. Typically
securities lending agents agree to indemnify clients against the risk of any decrease in the
value of non-cash collateral.
40. It is clear from the evidence that cash collateral is much more common, largely because it
can be reinvested at a profit. Where a securities loan is made against cash collateral, the
lender of the securities pays interest to the borrower. This will typically exceed the lending
fee paid by the borrower, meaning that there is a net amount (or rebate) due from the
lender to the borrower. This means that in order to make a profit, the lender must invest
the cash collateral at a return greater than the rebate.
41. The securities lending agent is mandated by the lender to invest the cash collateral on a
discretionary basis according to agreed investment guidelines. These set out the range of
securities in which the agent is permitted to invest. Two types of investment account are
maintained for clients. Most use commingled funds, in which cash collateral from multiple
clients is pooled for reinvestment. In such funds, each investor holds a proportion of the
portfolio according to the amount of collateral received for loans of its securities. There is
a common set of investment guidelines which are approved by each client. The evidence is
that of BNYMs six hundred-odd securities lending clients, all but about fifty used
commingled funds.
42. Some clients (of which AP was one) choose to have segregated accounts, in which cash
collateral received for loans of their securities is held and invested separately. Clients with
segregated accounts are free to agree their own investment guidelines. Subject to the
guidelines, investment is at the agents discretion.
43. Thus the crucial agreement in the present case is the Securities Lending Authorisation
Agreement (SLAA) between BNYM and AP which was signed on 22 December 2004.
The parties agreed a revenue split, with 85% to AP, and 15% to BNYM. An issue is as to
the meaning and effect of the investment guidelines contained in the agreement, and in
particular whether they marked AP out as a particularly conservative securities lending
client, as it claims.
44. While cash collateral is received and repaid in connection with individual loans of
securities, it is not generally invested as such, in the sense that securities loans are not
linked to specific collateral investments. What matters, I am told, is the net position with a
given counterpartya loan close-out may not require a return of collateral, and a new loan
may not involve a new posting of collateral, but only a notional reallocation of collateral
between loans. Typically, a proportion of the account will be held in cash or very short-
term (such as overnight) instruments. This is used to manage day-to-day variations. The
remainder is usually invested in longer-term and higher yielding instruments from issuers
on the agents approved list. It is this investment which generates the income.
45. When purchasing securities for investment, the evidence of Mr Zimmerhansl (which I
accept) is that it is common for a securities lending agent to make a large purchase that is
then split across a number of clients, according to their investment parameters. This allows
the agent to obtain a better price than would be possible from multiple small purchases.
This has been called a programme wide approach, whereby (as BNYM puts it)
decisions are taken in common across all clients insofar as these are consistent with their
individual investment guidelines. It has been the subject of dispute during the case, since
AP has maintained that BNYM was not entitled to manage its account on a programme
wide basis, insofar as it in fact did so.
46. According to Mr Zimmerhansl, investments are typically held until maturity, with sales
only in exceptional circumstances (e.g. if a client decides to withdraw from a securities
lending programme). I accept that, though it is clearly not a hard and fast rule. As
BNYMs policy documents recognise, particularly that of 28 July 2006 dealing with
Sales of Assets, sales of investments may be appropriate in the case of deterioration in
issuer credit profilein other words, if the issuer gets into difficulties.
47. In general, I am satisfied from the evidence that this is a high volume, low margin
business, operated in conjunction with the custodians primary function of holding
securities for the owner, and seen as generating a modest return at low risk.
The Sigma MTNs
The SIV sector
48. A central premise of APs case is that the Sigma medium term notes acquired for APs
account in 2007 were inherently unsuitable investments given its conservative risk appetite.
As BNYM says, that in turn is largely premised upon the nature of Sigma itself. There
was considerable evidence in that regard, from the parties experts, and from BNYMs
factual witnesses. Very different conclusions are drawn from it by the parties.
49. What is common ground is that Sigma was very similar to other entities commonly known
as SIVs (or Structured Investment Vehicles), and that although Sigma considered itself to
be a limited purpose finance company, it was considered by investors and analysts as
part of the SIV sector. Some of these were sponsored by banks, some (like Sigma)
were not. According to Mr Richard, as a result of increased demand for SIV securities by
investment managers, SIV debt issuance experienced tremendous growth during 2005 and
2006, increasing 45% in 2006 alone. The evidence is that SIV assets were nearly US
$300bn as of year-end 2006, and were projected to continue to rise at similar rates during
2007. The figure given by AP is US$400bn.
The establishment of Sigma
50. Sigma Finance Corporation was incorporated on 5 April 1994 in the Cayman Islands. The
founders were two individuals, Mr Nicholas Sossidis and Mr Stephen Partridge-Hicks,
who had previously (as Ms Demmler put it) invented the SIV when at Citigroup. They
managed Sigma through a London-based English company called Gordian Knot Ltd,
which as investment manager was regulated by the FSA.
51. Of all the SIVs, Sigma was the biggest issuer, with issued debt peaking at US$55bn in
2007. In July 2007, its debt had a weighted average life of 1.16 years. This implies a
huge rate of issue, showing, BNYM says, that by July 2007 Sigma was issuing (and
investors were purchasing) debt at a rate of almost US$1bn per week on average.
52. Stated simply, its business model was to issue securities in the form of short-term debt,
and use the proceeds to buy higher-yielding long-term debt, profiting from the difference.
This is aptly called maturity arbitrage in some of the material. The securities which
Sigma issued were in the form of commercial paper (CP) and medium term notes
(MTNs). There were a considerable number of such issues, with varying maturities.
CP maturities were less than a year, whereas MTNs had maturities of up to five years,
with several years being typical, according to Mr Servis. However, although BNYM has
compared Sigmas business model to that of a bank, it was not in my view seriously
comparable.
The structure of the securities
53. The MTNs in question were issued by Sigmas wholly owned Delaware incorporated
company, Sigma Finance, Inc, pursuant to a Private Placement Memorandum dated
November 1, 2005. This allowed for issues up to US$50bn of medium term notes
(MTNs) with maturities in excess of 300 days from date of issue. The notes were
guaranteed by Sigma Finance Corporation. There were relatively complex governing law
provisions which are not relevant for present purposes. The notes were issued in book-
entry form through The Depository Trust Company (DTC). The notes were floating rate
notes (a floating rate note is classified as a fixed income security because the interest rate
is reset at specified intervals, so that at any given date it is a fixed rate).
54. As explained by Mr Servis, and not in dispute, under the market conditions that prevailed
for the first twelve years of its existence, Sigma was able to fund itself because investors
typically rolled over its debt into new issues. What this meant was that when Sigmas
MTNs reached maturity, repayment was funded by issuing further MTNs, rather than by
selling assets in its portfolio.
55. Under the terms of the Private Placement Memorandum, the holders of MTNs had
security rights by way of a first priority floating lien over Sigmas asset portfolio, which
provided a reassurance of its ability to repay. The MTN holders had senior status by
virtue of the subordination of the capital note holders in the security structure. This
provided a capital cushion of some US$4bn, as against debt outstanding (according to a
table produced by BNYM in closing) of about US$53.4bn in August 2007, and about US
$24.3bn in August 2008. However, importantly, the memorandum stipulates that assets
used as collateral in repurchase agreements (repos) took priority. There is a dispute
between the parties as to the practical effect when repo transactions became a prime source
of funding for Sigma as the financial crisis deepened.
56. Probably the most important reassurance for investors, however, was not the lien over the
assets. It came from the credit rating agencies, whose endorsement was crucial to Sigmas
business model. Sigmas senior debt was AAA rated by all major credit ratings agencies
from its inception until April 2008. This includes the time in March/April 2007 when the
Sigma MTNs were purchased for AP. The AAA rating was also essential in keeping the
funding costs of the securities low, and thereby enabled the arbitrage that made the whole
structure profitable.
Sigma is added to BNYMs list of approved issuers
57. In common with other securities lending agents, BNYM maintained an Approved List
of issuers considered suitable for cash collateral investments. Only issuers on the
Approved List could be purchased as collateral for securities lending clients. Sigma was
added to the Approved List of Mellon Bank on 19 August 2005 (this being pre-merger),
on the basis of a review conducted by Ms Demmler.
58. APs case is that the review was deficient, and Ms Demmler did not understand the
complexities inherent in Sigma MTNs as securities. Among the points taken, AP says that
her review was brief and outline in nature, that there was no legal review of Sigmas
documentation, and that Ms Demmler was not aware that the securities were Non-
standard Investments under an internal policy document. Criticism is also made of the
fact that she did not mention in the review that the Sigma MTNs were Rule 144A
Restricted Securities or that they were Private Placements.
59. AP accepts that Ms Demmler did her best to assist the court, which is correct. It goes on
to submit however that her evidence as to what she did and, more significantly, what she
did not do, during the period from approval onwards revealed a shockingly imprudent
approach to credit analysis and a complete failure of reasonable diligence and competence
in the performance of her duties as credit research manager and analyst in relation to the
Sigma MTNs.
60. Having seen her give evidence over a day, I reject those criticisms. Ms Demmler began
her career at Manufacturers Hanover, which became Chemical Bank and was eventually
absorbed by JP Morgan. She joined Mellon Bank in 1995, and by 2005 was very
experienced in her role. Though the Sigma securities benefited from a AAA rating, she
said (and I accept) that she never relied solely on ratings.
61. Also, and importantly, Mr Tant reviewed and approved Ms Demmlers analysis of Sigma.
He said that the aim of the Approved List was to ensure that clients were invested only in
high quality assets. While client investment guidelines would include rating criteria, the
banks approach was to individually research securities. He said that, This reflected the
fact that Securities Lending and other cash investment strategies were intended to represent
relatively low-risk investments in which preservation of principal was a priority. That
said, any investment programme carries with it some degree of risk. Mr Tant trained as a
credit officer in 1983, when he joined Mellon Bank, and in 2004 he was appointed the
Chief Reinvestment Officer for Mellons securities lending group. He was a thoughtful
witness.
62. In view of the criticisms made by AP of Ms Demmlers alleged lack of understanding of
repos, it is to be noted that the review states that MTNs were secured over Sigmas assets
subject to carve out for repos The only priority claim ahead of Senior Notes are
security interests granted under repurchase agreements. This was a correct summary of
the position. Further, APs criticisms of her performance need to be seen against the
evidence of how widely Sigma was held as collateral by securities lenders.
63. The adequacy, or otherwise, of Ms Demmlers review is ultimately a matter of expert
evidence. Though Mr Servis described her analysis as short and simplistic, he has no
relevant experience of credit analysis in this context. BNYMs expert, Mr Richard, on the
other hand, does have more relevant experience. He regarded the review as detailed,
pointing out that it was supplemented by information from the credit rating agencies and
direct communication with the managers, Gordian Knot.
64. His conclusion was that, The detailed review shows that by identifying key risks as well
as mitigating factors, Ms Demmler had considered the same types of issues that I would
have focused on in performing a similar analysis. Based on the nature of this review, it is
my opinion that BNY Mellon acted reasonably in evaluating Sigma for inclusion on its
Approved List.
65. I prefer the evidence of Mr Richard to that of Mr Servis in this respect. It may be correct,
as AP says, that Ms Demmler did not fully appreciate the complexities inherent in the
Sigma MTNs, which the crisis was in due course to lay bare. However in my view, this is
a hindsight criticism. As I explain later, the evidence is that most of the investors in SIV
senior debt were money market funds, which BNYM describes as conservative
investors (and I consider that they were perceived as such), with most of the rest being
held in securities lending cash collateral pools.
66. It was Ms Demmler who came up with the term money good. She said in cross-
examination, My role was, you know, look at the assets and determine if we thought they
were essentially what we call "money good". Were they going to pay out at maturity.
The phrase was much cited by AP in its closing submissions. AP seeks to avoid the
obvious conclusion that Ms Demmler was justified at the time in regarding Sigma
securities as money good (as did the market generally) by attacking her analysis. No
valid criticism can, in my view, be made of her review. I reject this ground of APs
challenge to the acquisition of the securities.
The effect of the financial crisis
67. The evidence is that there was a marked increase in issuance in the SIV sector over the
period 2006 and early 2007. In retrospect, this was the peak of the bubble that had
developed for asset-backed securities. The so-called credit crunch is usually taken to have
begun in mid 2007, in June, July or at the latest August 2007, developing into a fully
blown global financial crisis in September/October 2008. It is not seriously in dispute that
from the onset of the credit crunch there was an attendant drying up of demand for the
securities issued by the SIVs, which meant that their business model became unviable,
though this was not immediately recognised at the time.
68. BNYM relies on a report issued by Moodys on 20 July 2007 entitled, SIVs: An Oasis of
Calm in the Sub-Prime Maelstrom. This report was one of a mass of reports and
commentaries adduced by the parties in which rating agencies, banks, investment advisers,
the financial press and others expressed opinions, to which the parties referred to
substantiate their respective cases. Both parties found ample ammunition in the material.
While the articles can be good indicators of contemporary market sentiment, and helpful in
charting the course of the crisis, it would not be appropriate, in my view, to give undue
weight to any particular opinion. This material was mainly relevant so far as it shed light
on the primary evidence.
69. An example can be given as follows. In its closing, AP cited a Wachovia Securities article
dated December 18, 2007. This states that with a ~67% spike in June MTN issuance
at Sigma Finance, the largest SIV on the street, we may have seen an attempt at shoring up
its position in anticipation of what occurred in the latter half of the year. The AP Sigma
MTNs were acquired in March/April 2007, so this is of doubtful relevance, even if
correct. Further, the article also provides support to BNYMs case, saying that, Many in
the sector likely anticipated 2007 to be a record year for SIVs, and as the troubles in the
mortgage and hedge fund markets intensified during July and August, both Moodys and
Standard and Poors published articles praising the performance of SIVs and their relative
insulation from the troubles of the broader credit markets.
70. This optimism proved to be hopelessly wide of the mark. The favourable reporting on
SIVs did not last. AP quotes an article published on 20 September 2007 by the credit
rating agency Fitch, saying that, The SIVs ability to secure ongoing funding is core to its
business model, which centres on maturity arbitrage by financing long-term assets to a
large degree with short-term liabilities. Continuous access to funding via the CP and
MTN markets is critical for SIVs to maintain normal operations.
71. That funding was becoming unavailable. In short, the market for the product dried up.
Further, the assets held in the SIVs portfolios were suffering with the rest of the market.
SIVs began to go into enforcement, which meant that they had failed their market value
test, and were wound up, beginning with Cheyne Finance on 28 August 2007. BNYM
points out that the initial view of the receivers was that its assets were not exceeded in
value by its liabilities (Re Cheyne Finance plc [2007] EWHC 2116 (Ch), at [4], Briggs J),
but this does not affect the overall picture.
72. An internal Standish email of 28 August 2007 says that, Today's news is as close to a
death knell as one can get for SIVs. The well-managed ones are going to suffer funding
problems no matter what, after Cheyne. This was an accurate appraisal.
73. The last securities which Sigma itself was able to issue were issued in October 2007. This
is highly significant, since its business was the issue of securities. From that time, barring
a revival in the market, Sigma was (to use the phrase used by one of the witnesses) in run
off. However it should not be assumed that this was an orderly process. One way or
another, Sigma had to use its asset portfolio to meet maturing liabilities. It did so largely
by raising funds through repos, that is, loans collateralised on its portfolio, and what have
been called ratio trades, by which it redeemed notes at par against the purchase of its assets
at a ratio (usually) of three to one. This was not a process which could go on indefinitely.
An important question in the case is as to the extent to which BNYM nevertheless still
regarded Sigma as essentially sound, in the sense that its assets, capital and ability to
continue to raise money were such that (as BNYM contends) it reasonably concluded that
noteholders were likely to be paid on maturity.
74. In early April 2008, Sigma was downgraded below AAA, though it was still investment
grade paper. (According to BNYM, the US$5.5m tranche maturing 12 March 2009,
which was less than a year from maturity, continued to have the high ratings.) It was this
downgrade, and more particularly the drop in the indicative price being provided to the
bank by its pricing vendors, that led to clients (including AP) being contacted by BNYM
in May 2008. The adequacy of such contact raises another important question in the case.
The end of Sigma
75. At the beginning of September 2008, Sigma was still rated A by Standard & Poors
(S&P), and A3 by Moodys. BNYM relies on S&Ps report of 12 September 2008, to
the effect that as of 10 September 2008 Sigma had assets of over US$27.5bn to meet US
$23.5bn of secured liabilities, including US$17.3bn in repos and US$6.2bn of MTNs.
This is discussed further below, but notwithstanding passages from the reports of the
agencies, I am satisfied that by now Sigma was hugely vulnerable.
76. The bankruptcy of Lehman Brothers on 15 September 2008 precipitated a drop in the
value of many of the investments that made up Sigmas portfolio. That, in turn, led to
increased margin calls from repo lenders. On 30 September 2008, Sigma defaulted, and
its securities were downgraded by the rating agencies to junk status. Receivers were
appointed on 6 October 2008.
77. BNYM calculates that on 6 October 2008, some 97% of the portfolio (just under US
$27bn) had been seized by repo counterparties, leaving assets of US$700m to meet
remaining MTN liabilities of US$6.2bn comprising outstanding MTNs, including APs
(Re Sigma Finance Corp [2008] EWHC 2997 (Ch) at [7]).
78. There subsequently ensued litigation over the correct interpretation of Sigmas security
trust deed. There was a difference of opinion in the courts as to priority of payment, and
BNYM says that by the time the Supreme Court (by a majority) allowed the appeal from
the courts below, the assets had erroneously already been sold at fire-sale prices for just
US$450m. In any event, there was bound to be and was a large shortfall.
The Securities Lending Authorisation Agreement
79. Having set the scene factually, it is now necessary to examine the legal relationship
between the parties, which is based on the SLAA entered into between them.
The making of the agreement
80. Prior to its relationship with BNYM, AP began a securities lending programme in March
2002 with Citibank, which was at that time APs custodian. As Ms Hammarlund explains,
a positive decision was made not to allow Citibank to invest any of the cash collateral. In
2004, consonant with its obligations as a public authority to ensure that it was receiving a
competitive service, AP decided to tender for a new custodian relationship. The focus of
the procurement was on custody services, but AP was also looking for the custodian bank
to provide securities lending services. Having now had some experience of the way
securities lending worked, Ms Hammarlund made it clear that AP had also decided that it
now wanted a cash collateral programme.
81. On 18 February 2004, AP issued a notice inviting tenders for global custody and related
services. There were four preferred bidders, each leading securities lenders, including
ABN AMRO Mellon Global Securities Services B.V. This company was originally a
joint venture between ABN AMRO and Mellon Bank, formed to enable Mellon to market
its services to clients outside the US. BNYM is the legal successor to that company, and
for convenience I shall continue to use the term BNYM to describe it.
82. In its responses, BNYM addressed various issues raised by AP, and provided information
about its pooled funds for cash collateral investments, and investment parameters, as well
as the possibility of a segregated account. It stated that our strategy for collateral
investment centers on preservation of principal and maintenance of proper liquidity by
managing interest rate risk. I agree with AP that this was a clear statement of how
BNYM would approach its task if selected.
83. A number of meetings and exchanges took place between AP and the tenderers, including
BNYM. On 30 July 2004, BNYM sent a response to various questions which had been
put to it by AP. It explained that its Global Securities Lending Asset Review Committee
met bi-weekly to review issuers as well as reinvestment issues. It explained that credit
research was the function of the banks Compliance Risk Management Group. It explained
the credit review process by which the financial stability of issuers was monitored.
Through the credit review, it said, the bank is able to take immediate action to remove a
name from our Approved Issuer List and/or recommend selling the issue, if appropriate.
84. In the event, AP retained BNYM to provide global custody services pursuant to a Global
Custody Agreement dated 25 October 2004 (the GCA). The GCA envisaged that
BNYM would also be engaged to provide securities lending services, and there were
continuing discussions in that regard in which AP was assisted by an external consultant
(Mr Roland Nilsson).
85. At a meeting of APs Risk and Returns Committee on 29 November 2004, Mr Grunditz
recommended the segregated account option, and the decision was taken to proceed on that
basis. A Securities Lending Authorisation Agreement was duly signed on behalf of AP
and BNYM on 22 December 2004. It was agreed that the net securities lending
revenues would be shared. The agreed split was 85% to AP and 15% to BNYM (the
most favourable on offer from the four tenderers).
86. AP said in opening that the SLAA was a freestanding agreement, separate from the GCA.
They were clearly different agreements, but equally in my view they were linked
agreements, and BNYM performed both roles, in accordance with what the evidence
suggests is the usual practice in the securities lending industry. (This is of some relevance
in relation to terms in the GCA which dealt with conflicts of interestsee below.)
The terms of the agreement
87. By the SLAA, which was subject to English law and jurisdiction, AP authorised BNYM
to establish, manage and administer a Securities Lending Program in accordance with the
provisions hereof (the "Program") with respect to the lendable securities held by [AP's]
Portfolio. Not all securities were lendable, for example those of Swedish issuers, as AP
later made clear.
88. As APs lending agent, BNYM was authorised to lend securities held for AP to
counterparty borrowers, and was authorised to invest and reinvest cash collateral in
accordance with Investment Guidelines attached to the SLAA as Exhibit B. This authority
is given by clause 6 of the SLAA, which also stipulates for the cash collateral to be
invested in a segregated rather than a commingled account:
"6. Collateral Investment
[BNYM] is hereby authorized to invest and reinvest, on behalf of the Portfolio, any
and all cash Collateral received in respect of loans of the securities of the Portfolio
in accordance with the provisions hereof. Cash Collateral received by the [BNYM]
on behalf of the Portfolio shall be invested, held and maintained by [BNYM] in a
segregated cash collateral account established and maintained by [BNYM] for the
benefit of [AP]. The assets of such segregated cash collateral account shall be
invested and reinvested by [BNYM] in accordance with the investment guidelines
established for such segregated account, a copy of which guidelines are attached
hereto as Exhibit B ("the Investment Guidelines") which guidelines may be revised
or substituted from time to time upon the agreement of [BNYM] and [AP].
[BNYM] is hereby authorized to cause the investment and reinvestment of all cash
Collateral held in respect of loans of the Portfolio's securities in accordance with the
Investment Guidelines."
89. Clause 10(a)(ii), is part of a Risk of Loss clause. By it, AP agreed that losses resulting
from investment of the cash collateral were for its account, except where the losses resulted
from BNYMs negligence. AP:
acknowledges and agrees that any losses of principal from investing and
reinvesting cash Collateral (Principal Losses) shall be at the Portfolios risk and
for the Portfolios account except to the extent, if any, that such Principal Losses
result from the negligence or wilful default or fraud of the Lending Agent, or the
failure of the Lending Agent to comply with the provisions of this Agreement.
90. Clause 10(b)(i) SLAA is an important provision which defines the Standard of Care
required of BNYM:
The Lending Agent shall perform its obligations under this Agreement with the
care, skill, prudence and diligence which, under the circumstances then prevailing, a
prudent person acting in a like capacity and familiar with such matters would use in
the conduct of an enterprise of like character and with like aim.
91. Clause 10(b)(ii) SLAA is a Limitation of Liability, providing that
Except to the extent, if any, otherwise specifically provided herein, the Lending
Agent shall not be liable with respect to any losses incurred by the Client or the
Portfolio in connection with this Agreement or the Program, except to the extent
that such losses result from the Lending Agents negligence or wilful default or
fraud in its administration of the Program, or the failure of the Lending Agent to
comply with the provisions of this Agreement. Notwithstanding any other
provision of this Agreement, under no circumstances shall the Lending Agent be
liable for any indirect, consequential, or special damages with respect to its role as
Lending Agent.
92. Thus losses resulting from BNYMs negligence and failure to comply with the SLAA do
not fall within the exclusion (this is not a case raising issues as to indirect damages, etc.,
referred to in the exclusion). BNYM submits that it is not open to AP to advance claims
for breach of fiduciary and regulatory duties, in respect of which it alleges neither fraud
nor wilful default, but because of the view I take as to APs case in respect of such duties,
I need not decide the point.
93. The Investment Guidelines are Exhibit B to the SLAA. This is headed Frsta AP-
Fonden U.S. Dollar Cash Collateral Reinvestment Account (hereinafter the Account).
The guidelines have four sections (or clauses). The first is headed Objectives, and
provides as follows:
The Account shall be for the management of cash collateral supporting securities
loans, the key objectives of which are to:
- keep all cash collateral and related investments in a segregated account(s) in the
name of [AP]
- safeguard principal
- assure that all cash collateral is invested in a timely manner
- maintain a diversified portfolio of investments
- maintain adequate liquidity in the Account to meet the anticipated needs of [AP]
and/or its investment advisors; and
- consistent with these objectives, to optimize the spread between the collateral
earnings and the rebate rate paid to the borrower of securities.
The following standards have been designed to complement the preceding
objectives.
To be eligible for cash collateral investment, a security must be rated by both
Moodys Investor Service and Standard & Poors (Rating Agencies) at the
required quality level at the time of purchase.
94. There then follow the remaining three sections. Section 2 begins, Acceptable cash
collateral investment instruments include. There follows a list of instruments, and the
required rating (except in the case of US treasuries). Thus section 2d) permits investments
in instruments issued by domestic corporations (that is US corporations) including
corporate and floating rate notes rated A2/A or better. Section 2h) permits investments in
Asset-backed securities rated AAA. There was some debate as to which of these
categories the Sigma MTNs fell into, but it is not now in dispute that they were asset-
backed securities which were rated AAA at the time of purchase, and so eligible
investments under the guidelines. Investment in some types of instrument was expressly
prohibited, including derivative securities.
95. Section 3 begins, Maturity and duration constraints are as follow. Section 3a) sets a
portfolio-wide weighted average maturity (WAM) of 30 days. Section 3c) requires
floating rate notes to have a maximum term of two years, or in the case of asset-backed
floating rate notes, a projected maximum life of two years and a final stated maturity not
exceeding five years. Again, it is not in dispute that this covered the Sigma MTNs.
96. Section 4 begins, Diversification standards are as follows. There are two relevant ones
(both of which are in dispute as regards the Sigma MTNs). Section 4e) provides that No
more than forty percent of the Account may be invested in floating rate securities.
Section 4h) provides that, The Account may not be invested in illiquid securities. For the
purposes hereof, an illiquid security is defined to be an issue that is not sellable without the
sale proceeds being materially impacted due to a lack of other trading activity in the
security. .
97. There are a number of points in issue on the effect of the SLAA and particularly the
Investment Guidelines. As identified by the parties these are:
(1) Was preservation of principal part of the mandate?
(2) Were the Investment Guidelines applicable at time of purchase only?
(3) What was the scope of BNYMs duty to communicate with AP?
(4) The commingled fund and programme approach issues.
(5) Did BNYM owe AP fiduciary duties?
(6) The scope of the contractual standard of care.
98. Some of these are only relevant if I find in APs favour on its contentions. Thus, if the
acquisition of the Sigma MTNs in fact complied with the safeguarding principal
objective at the time of acquisition, then it may be academic whether (as AP argues) this
objective was part of the mandate. If BNYM in fact monitored Sigma with due care over
the relevant period, the disputed scope of their monitoring obligations may be likewise
academic.
(1) Was preservation of principal part of the mandate?
99. In the response which BNYM sent to AP on 30 July 2004 as part of the tendering
process, it said that, Chief among Mellon Banks reinvestment objectives is the
preservation of your principal. APs case is that this was also its chief objective. Despite
a number of points that BNYM has raised, as a matter of evidence, and of common sense,
I accept that this was indeed the position.
100. Based on it, AP has a breach of mandate case to the effect that the safeguard principal
objective, which is contained in section 1 of the Investment Guidelines, was part of the
banks mandate, in the sense of defining the banks authority to make investments.
101. AP contends that on a proper construction of the scheme of the SLAA Investment
Guidelines, the key objectives as set out in section 1 set out the risk profile and objectives
to be achieved in the management of the cash collateral in its account, and the following
sections 2, 3 and 4 set out standards or tactics by which those objectives could be
achieved. It says that the latter tactics were secondary, and designed to complement
the key objectives which were, at all times, of primary and overriding importance. Based
on this construction, AP puts its case in breach of mandate, contending (to quote its
closing submissions) that only investments which when purchased had a near certainty
of payment were within the mandate and objectives agreed.
102. A number of textual points are made by AP to support its construction. It is said to be
necessary to give effect to the word objectives. It is said that passing the threshold of
eligibility does not mean that the overall objectives under section 1 can be ignored.
Reliance is placed on the evidence as to the approach of BNYMs Credit Analyst Group,
which (it is not in dispute) looked beyond the rating criteria.
103. BNYM submits that the objectives section in the Investment Guidelines should be read
as setting out the basis on which the detailed provisions following were selected, rather
than as themselves imposing separate obligations. It submits that under the SLAA, it was
authorised to invest cash collateral in accordance with the Investment Guidelines. Nothing
in the SLAA required it to apply a higher standard when making investments than that set
out in the Investment Guidelines. The operative provisions of the Investment Guidelines,
governing which securities could be purchased for AP, are those under sections 2-4. The
objectives section does not have any independent effect and does not modify the formal
requirements of sections 2-4 with regard to credit quality, liquidity or diversification.
104. My conclusion on the point of construction is as follows. Clause 6 of the SLAA, which I
have set out above, authorises BNYM to invest in accordance with the Investment
Guidelines in Exhibit B. This constitutes the banks authority, or to use the phrase used in
the case-law in the banking context, the banks mandate. So, for example, a bank paying a
cheque with a forged signature is said to have paid in breach of mandate, because the
customer never authorised it, and the payment is treated as for the banks own account
(Barclays Bank Ltd v WJ Simms Son & Cooke (Southern) Ltd [1980] QB 677 at 699,
Robert Goff J).
105. In this case, AP seeks to construe the safeguard principal objective as part of the
mandate. I do not accept that submission. As a matter of commercial sense, it is important
that the authority of a lending agent to invest cash collateral on behalf of a lender is clearly
defined, for the protection of both parties. As BNYM says, a requirement to safeguard
principal is too vague to be of contractual effect as part of the mandate. As a matter of
construction, I consider that the objectives section of the Investment Guidelines (as it says)
states the key objectives for the management of the cash collateral, including the safeguard
principal objective. But the scope of BNYMs authority to invest, in other words its
mandate, is defined in the subsequent sections. These are the sections which specify the
type of instrument that is eligible for acquisition as collateral, the rating and maturity
requirements of such instruments, and the overall diversification standards for the account.
(2) Were the Investment Guidelines applicable at time of purchase only?
106. There is a dispute between the parties as to whether the Investment Guidelines applied at
the time of purchase only, as BNYM submits, or whether they continued to apply so long
as the investments were held on APs account, as AP submits. This is linked to an issue
between the parties as to BNYMs ongoing duty to monitor the investment portfolio for
compliance with the guidelines. BNYM says that it was not under such a duty. The
issues are relevant to APs retention claim.
(a) APs case
107. AP submits that BNYM was contractually obliged to monitor the investments in its
account post-acquisition on an on-going basis to ensure that the account remained in
accordance with the Investment Guidelines. AP accepts that the guidelines expressly
provide that ratings criteria were to apply on acquisition only. But, it says, BNYM held
itself out to AP as having, and both parties understood BNYM to have, obligations to
manage and to monitor the investments in AP's account post-acquisition for on-going
compliance with the Investment Guidelines. The provision as to ratings only meant that
there was no automatic sale of the security out of the account if a rating was lowered.
108. In particular, to quote from its closings, AP contends that BNYM was obliged under the
terms of the SLAA to manage and to monitor the investments in AP's cash collateral
account post-acquisition - in order to achieve the key express objective to safeguard
principal. This meant that BNYM was obliged to monitor and manage the account for
compliance with the objective of ensuring that the securities remained money good (i.e.
near certainty of full principal repayment), and to ensure ongoing compliance with AP's
investment guidelines.
109. To give support to its construction, AP relies on the fact that section 1 provides that the
account is to be for the management of cash collateral with the objective of maintaining a
diversified portfolio of liquidity. AP also makes reference to material both before and after
the conclusion of the SLAA. On 30 July 2004, BNYM sent AP a response to follow up
questions raised by AP in the tender process. Under the heading Continual Monitoring it
said that, In addition to a formal yearly review, Mellon Banks team of credit analysts
monitor our issuers on a daily basis. Daily monitoring is vital to stay ahead of any credit
problems that may arise and to anticipate potential downgrades in advance of rating agency
announcements. The response also said that, on the reinvestment side, Mellon
Bank as manager of cash re-investment activities utilises a combination of automated and
manual process and procedures ensures that cash collateral investments conform to
investment guidelines. I agree with AP that the latter appears to be an assurance that there
will be continuing compliance with the guidelines.
110. Internal Mellon Bank securities lending policy documents (though made after the
agreement was entered into) are also relied on by AP, and in parts suggest a continuing
duty to monitor, including a statement that separately managed accounts "will adhere to
client prescribed liquidity targets". As against that, what seems to be the most explicit
statement of all in the policy documents is to the effect that All investment guidelines are
applicable at the time of purchase.
111. AP put to a number of witnesses that management of risk implies a dynamic review, and a
constant review of issuers, and Mr Blanchard in particular agreed. AP also relies on his
evidence to the effect that the bank would have to monitor the clients investments.
112. AP places particular reliance on the evidence of Mr Fort that, Once investments were
allocated to appropriate portfolios by the cash reinvestment group, one of the tasks of the
portfolio managers was to monitor the adherence of their portfolios to their respective
investment guidelines, as well as to analyse and review each client's asset liability mix and
cash flow". In oral evidence BNYMs experts Mr Zimmerhansl agreed with this
statement and Mr Richard said that it was his experience as well.
113. AP also places reliance on the deposition of Mr Fort in the Oklahoma proceedings that I
mentioned on 20 January 2011, where in a discussion on investment guidelines (and
leaving out objections) he says as follows:
"A: The clients sign off on investment guidelines and give Bank of New York
Mellon security lending the authority to execute on behalf of that, the client, within
the contract, the guidelines.
Q: Does BNY also take on the responsibility to monitor those investments, after it
makes the initial investments in the -- when it makes the initial investment in the
portfolio?
A: Yes, Bank of New York Mellon monitors the investments in the portfolio, on
an ongoing basis.
Q: And that's the bank's responsibility, not the client's responsibility..."
A: Yes."
114. Finally, the four annual compliance reports dated 28 February 2005, 31 January 2006, 31
January 2007 and 31 January 2008 are headed Compliance Checklist Investment
Restrictions. I agree with AP that they demonstrate that BNYM did in fact seek to
monitor AP's account against the Investment Guidelines.
(b) BNYMs case
115. BNYM submits that the Investment Guidelines are to be construed as applying only upon
the purchase of investments. They do not govern BNYMs obligations with regard to
existing investments.
116. BNYM submits that the purpose of the Investment Guidelines is set out at clause 6
SLAA, pursuant to which BNYM was authorized to cause the investment and
reinvestment of all cash Collateral held in respect of loans of the Portfolios securities in
accordance with the Investment Guidelines. The authority granted is to cause the
investment and reinvestment of all cash Collateral. To cause an investment means,
BNYM submits, to apply funds to the purchase of a security. This makes explicit that the
function of the Investment Guidelines is to determine what can be purchased for APs
account at any given time, rather than to provide a set of ongoing requirements governing
whether or when to hold or sell investments once purchased. The effect of clause 6 SLAA
is therefore that BNYM is empowered to invest APs cash collateral in any investment
which, at the time of investment, satisfied the criteria of the Investment Guidelines.
117. Based on Mr Blanchards evidence, BNYM submits that while evidence of pre-
contractual negotiations is of limited relevance, it is clear that AP well understood, on
entering into the SLAA, that its Investment Guidelines would apply only at time of
purchase. I do not accept this submission, which is contrary to the evidence of Ms
Hammarlund.
118. In addition, BNYM relies on its expert evidence. Mr Richards evidence was that in the
absence of specific language to that effect, it was not standard [practice] to alert a client of
a security falling out of compliance if the thought was to stay the course and to continue to
hold the investment. Mr Zimmerhansl said that continual monitoring does occur, but
drew a distinction between continual monitoring and compliance with the original
acquisition criteria.
119. In summary, BNYM accepts that it did perform ongoing credit monitoring of investments,
but it says that it did so on a programme-wide basis via the Credit Analyst Group. It
accepts that it is good practice to monitor investments on their approved lists. It does not
follow however that absent an express provision in the Investment Guidelines requiring
ongoing monitoring, it had a legal obligation to do so. Rather given the number and
diversity of its clients, it is difficult to see (it says) how in practice such a duty could be
applied.
(c) Discussion and conclusion
120. The question of the post-acquisition application of the Investment Guidelines is a matter of
construction of the agreed terms. The only express provision dealing with the point is in
section 1, which states that to be eligible for cash collateral investment, a security must be
rated AAA by both the main ratings agencies at the time of purchase. However, this does
not settle the timing question as to the rest of the guidelines.
121. As to the contractual language, on BNYMs case, I do not think that the words to cause
the investment says anything about whether or not compliance must be ongoing. On the
other hand, I consider that the provision that the account is to be for the management of
cash collateral with the objective of maintaining a diversified portfolio of liquidity
supports APs case that the intention of the parties was that there would be ongoing
monitoring of the account by BNYM.
122. BNYM draws a distinction between an obligation to monitor an account for compliance on
an ongoing basis, as new investments are being made for it, and an obligation to monitor
the individual investments in that account for ongoing compliance. There is perhaps a
distinction, but the concepts obviously overlap.
123. BNYM points out that the pre-contract negotiations and the implementation of the contract
by BNYM are not admissible in construing the contractual terms. But I think it is
common ground that good practice on the part of a securities lending agent such as
BNYM can be taken into account in ascertaining the meaning of the written terms. This is
because, What the parties agreed, explicitly or implicitly, can only be judged against the
factual background they knew, which must include practices of any particular market in
which they operate and in which the agreement was made (Crema v Cenkos Securities plc
[2010] EWCA Civ 1444 at [45], Aikens LJ).
124. Whether as a matter of obligation, or good practice, it is clear that BNYM monitored the
account, and monitored individual issuers. It would be surprising if it did not do so. I
have set out the details above and need not repeat them. I reject BNYMs suggestion that
all this shows is verification that investments complied with the Investment Guidelines at
their time of purchase.
125. However, there are limits as to how far this point goes. As BNYM says, many aspects of
investments, such as the issuer, maturity date and asset type, will not be expected to vary
over time anyway. Ratings can vary, but the Investment Guidelines expressly state that
rating criteria apply at time of purchase. I think that BNYM is right to say that in terms of
APs Investment Guidelines, the only provisions that could theoretically impose any
ongoing obligations are those dealing with diversification and liquidity.
126. As to diversification, section 4e) of the Investment Guidelines provides that no more than
40% of the account may be invested in floating rate securities. The Sigma securities fell
within this category. There are other similar provisions. BNYM says that it is not
practical for the lending agent to manage the cash collateral account on the basis of an
ongoing restriction, because it is outside its control to ensure compliance. The makeup of
the account is liable to fluctuate significantly on a day to day basis, with the lending agent
having no advance notice. An account may go in and out of the limit.
127. The conclusion that BNYM seeks to derive from this is not, in my view, supported by the
facts of the present case. On 28 February 2008, following a review of AP's account,
BNYM realised that floating rate notes amounted to 55% of its portfolio. Its
contemporary emails say that this was not "a technical violation and is in fact an
operational error on our part", and that the account "has been in breach for months". Quite
clearly, BNYM regarded this as a breach of its contractual obligations. The matter was
brought to APs attention, and resolved with APs approval by closing positions without
taking losses. The account was brought back within the limit by 20 March 2008.
128. Turning to liquidity, section 4h) of the Investment Guidelines provided that the account
was not to be invested in illiquid securities. However, monitoring the continuing liquidity
of particular investments would be a far more difficult exercise than monitoring the 40%
limit on securities with a floating interest rate just discussed. In fact, two expert market
professionals are in dispute as to whether the Sigma MTNs ever satisfied the liquidity
requirement, and the parties are not in agreement as to what liquidity means in this context.
129. Further, BNYM submits that it would make no sense to apply the liquidity requirement as
an ongoing prohibitionthe prohibition makes sense in the context of new investments,
but if applied on an ongoing basis, it would imply that BNYM was under an obligation to
sell securities at the precise moment when such a sale was most likely to expose the lender
to an unnecessary loss. This in my view is a reasonable submission.
130. My conclusion on this issue is as follows. I reject BNYMs submission that it was under
no obligation to monitor investments for compliance subsequent to purchase, and that it
was not obliged to monitor the credit quality of investments post-purchase. In my view,
on the construction of the agreed terms, BNYM had an on-going duty to monitor the
account for compliance with the Investment Guidelines. That duty included paying
continuing regard to the key objectives, but as objectives, not as part of its mandate. (It is
not necessary to add further words to the safeguard principal objective, as AP sought to
do, because it is self explanatory.)
131. Beyond that, I consider that question of compliance depends on the nature of the guideline
in question. BNYM was, in my view, under an ongoing duty to see that no more than
40% of the account was invested in floating rate securities, and if the limit was exceeded,
to take steps to bring the account back into compliance.
132. In my view, however, the guideline which provided that the account was not to be invested
in illiquid securities raises different considerations. I prefer BNYMs case that it applied at
the time of acquisition of the securities in question, but not on a continuing basis. I
consider that this gives a sensible commercial meaning to section 4h) taken in context. The
alternative finding that AP asks me to make, namely that BNYM was obliged to monitor
and manage the account with the objective of ensuring that the securities remained money
good (ie near certainty of full repayment), would have been completely unworkable.
133. In any case, I cannot see that the contract required the bank to dispose of the securities
upon them becoming illiquid. That would be inconsistent with the safeguard capital
objective if it resulted in an unnecessary loss, and would make no commercial sense. AP
came close to accepting this obvious point in oral closings.
(3) What was the scope of BNYMs duty to communicate with AP?
134. In its closing submissions, AP contends that full and open communication between
BNYM and AP on matters concerning AP's Account was in accordance with BNYM's
fiduciary responsibilities to AP, was expected (on both sides) and was in accordance with
market practice. AP appears therefore to put its case in this respect on the basis that
BNYM owed it fiduciary duties. The main finding it seeks is that BNYM was obliged to
provide full and open communication between BNYM and AP as soon as there was a
problem with a security which threatened the near certainty of repayment in full at
maturity.
135. BNYMs case is that the level of communication required by it was set out in the Global
Custody Agreement and, specifically, the Service Level Agreement annexed thereto which
provided for BNYM to report via its online Workbench system. In addition, AP
requested reports to be sent to it daily, which included information on the rating of
securities. As regards other information such as market concerns, that formed no part of
the contract with BNYM. It relies on the fact that AP's own evidence is that its witnesses
did not expect BNYM to be providing it with information about investments, expecting the
bank to manage the portfolio itself.
(i) What was specified under the contract
136. The first question to address is what was specified by way of communication from
BNYM. The GCA refers to a Service Level Agreement, though the copy in the
documents is unsigned. It states in very general terms that BNYM will provide AP with
details of collateral holdings proving they are covered by the appropriate percentage, as
agreed in Securities Lending contract, against their outstanding loan positions via
Workbench.
137. Ms Hammarlund describes in her evidence what was provided through Workbench,
which is a web-based information reporting tool. There were various reports available to
AP. This included pricing information on the securities, which (as described later) was
provided by IDC, a pricing vendor. Mr Grunditz explains that his understanding was that
the market value figures on these reports were only updated on a monthly basis, and I
believe that this is correct.
138. When it entered into the agreement, however, AP also required a daily report, which
showed the securities held in the cash reinvestment portfolio and certain other information
including maturity dates, ratings, par values and amortized cost. These daily reports did
not include pricing. The example I have seen runs to five pages, and shows both
acquisitions of the Sigma MTNs under SIGMA FINANCE.
139. Mr Grunditz says that he reviewed the holdings reports on a relatively infrequent basis. In
cross examination, he said that he reviewed them perhaps once a quarter, and once every
six months there was a random sampling of the portfolio. He said that AP did not have
the resources to carry out any in depth analysis. Although it had a risk-management
system called Dimension, for technical reasons it was not possible to monitor the cash
collateral portfolio through the system. He said that BNYM had emphasised its monitoring
of investments as one of its selling points in the tendering process, and AP relied on the
bank to do this.
140. So far as factual, I accept Mr Grunditzs evidence in this regard. However, it does not
alter the fact that AP knew from the daily reports that BNYM had acquired the Sigma
MTNs as collateral for its account. I agree with BNYM that neither Mr Grunditz nor any
other AP officer seems to have done very much to monitor the risks to which AP was
exposed through its cash collateral portfolio. Their response was that they trusted BNYM
in that regard, and could not practically interfere in its discretionary mandate. This is a
reasonable response in itself, but as investment professionals I consider that they could
have done more.
(ii) Discussion and conclusion
141. My conclusion is as follows. In agreement with BNYM, I consider that the alleged duty
of full and open communication on matters concerning the securities lenders account is
imprecise. As BNYM says, it was a discretionary investment manager, not an adviser of a
party which was going to take its own investment decisions. Its role under the SLAA was
to manage APs portfolio within the bounds of the Investment Guidelines.
142. The bank says that if the court were to find that discretionary investment managers were
required to keep clients fully informed about their portfolios, including providing
information on any market concerns and their own views relating to the investments in
client portfolios, this would cause an earthquake in the discretionary management
industry, both for managers (who would be obliged to completely overhaul their reporting)
and their clients (who would find themselves on the receiving end of masses of
information).
143. I accept BNYMs submission in this respect. Although Mr Blanchard seemed at one
point in cross examination to express the view that the bank was under a duty to disclose
all material facts to the client, he was on the sales side of the business, and may not have
understood the implications of what he was being asked. Mr Zimmerhansl made it clear in
re-examination that this was not his view.
144. The facts of this case illustrate that this was not the intention of the parties. APs
witnesses made it clear that they did not expect the bank to be providing it with information
about investments beyond what was agreed. Quite the reverse, they expected the bank to
get on and manage the portfolio without reference to AP. Up to May 2008, I am satisfied
that BNYM provided AP with the information that the parties had specified, and that was
adequate. That did not preclude AP asking for more information.
145. In normal circumstances, BNYM was under no obligation to do more than this. I consider
APs case that BNYM was obliged to provide full and open communication between
BNYM and AP as soon as there was a problem with a security which threatened the near
certainty of repayment in full at maturity is unworkable, and I reject it.
146. However, the question remains as to the banks duty to communicate with its clients if
things went wrong. This was the subject of considerable cross examination by AP of the
banks witnesses. They put it in slightly different ways. The following exchange took
place with Mr Mannix. He was on the trading side of the bank, responsible for cash
collateral reinvestment (reporting to Mr Ford and later Ms Rulong) but was the most
senior witness called by the bank, apart from Mr Ford, and was a good witness.
Q. And I know you don't deal with customers and it may, therefore, not be for
you to make this call, but would you agree with me that that is the kind of
information that clients like AP are entitled to have. If there are concerns about an
issuer, it's only right that they should be brought to the attention of the lenders.
A. I would imagine it depended upon the severity of the concern. I would agree.
Q. Then if we can go to --
A. We are -- I apologise -- I will try to be quicker in my answers. The bank is
tasked with making investment decisions and as such, we monitor the portfolio.
So if it became -- if we became sufficiently worried that we were looking to sell a
security at a loss, we would notify a client.
147. The evidence of the banks expert, Mr Zimmerhansl, was significant because he presently
runs a securities lending operation. In his witness statement he said that BNYM was
under no obligation to communicate to AP that the Sigma securities were impaired. He
said that in his experience, when information is passed to a client, it is done simply to
provide the client with information as a courtesy. In this regard, the following exchange
took place in cross-examination.
A. I think the fact that the Sigma asset had become significantly impaired is the
issue that actually triggered the need to actually communicate to the client, actually
say that. So there wasn't anything in the document, in any of the documentation
I've seen, that actually compels Bank of New York every time there's an asset that
falls below a certain value or you believe it to be impaired, you must communicate
that to us, so that's what I mean by as a courtesy. Clearly best practice would
suggest that you would do that, right, but the point is that there was no sort of
requirement that I saw for Bank of New York to do that.
MR JUSTICE BLAIR: But there would be if it was significantly impaired? I just
want to be sure I have understood your evidence, you see.
A. I think while there wouldn't be actually a specifically laid out requirement you
would expect to do it. Securities lending investments very seldom go wrong, just
in general, so these kind of things stand out and you would normally
communicate them to a client because a client -- their normal expectation is that in
the operation of the business they wouldn't experience loss.
This is one of the ways why it is different to a normal investment management
mandate where losses are just a course of investing. Securities lending, it's
exceptional for there to be a loss, so if you felt that there would be a potential for a
loss it would make sense, as I said, as part of best practice, to actually
communicate that to the client.
MR JUSTICE BLAIR: Best practice or duty or what?
A. Again, these things happen so seldom, I think they stand out and I would be
surprised if any of the investors in an asset like Sigma or was performing as
Sigma was at that time, that they didn't communicate it to the client, so you could
say that that would be common practice, but it would also be best practice just to
advise them, even if you didn't expect there to be a loss eventually.

Q. Would you agree with me, Mr Zimmerhansl, that if the bank had concerns
about Sigma as a matter of prudent banking practice you would expect the bank to
convey those concerns to the client?
A. Yes.
148. As this evidence makes clear, so far as securities lending is concerned unlike in some
other investment contextsit is exceptional for there to be a loss. This reflects the fact,
discussed elsewhere in this judgment that a key objective in relation to cash collateral is to
safeguard principal. The fact that the situation is unusual fits with the contemporary
evidence. As I explain later, the bank regarded the treatment of customers as regards
Sigma as fairly uncharted territory. The adequacy of its communications with AP
during this period has to be seen in that light.
149. On the evidence, I am satisfied that in performing its obligations under the agreement with
its client, it is best practice for a securities lending agent to communicate with its client if
there is a serious risk of loss in respect of securities held as collateral for the clients
account. BNYM says that the mere fact that something is best practice does not
necessarily mean that it arises as a matter of obligation, with which I agree. BNYM also
says that a contractual duty of care such as that found in clause 10(b)(i) of the SLAA
requires a party to carry out its obligations under the contract with the requisite level of
care and skill, but does not impose additional obligations not otherwise found under the
contract. Whilst that proposition may be correct in general terms, in this case it is not
disputed that there was a contractual duty to communicate. In performing that obligation,
BNYM had to exercise the contractual duty of care, that is, to the standard of a careful and
prudent securities lending agent. I am satisfied that this may require communication with
its client if there is a serious risk of loss in respect of securities held as collateral for the
clients account. This is not an extravagant obligation, and is one that was recognised by
the banks own officers. Whether it does so, or not, depends on the facts, as does the
scope of the communication. Where (as here) the securities lending agent is not acting in
an advisory capacity, there may be no obligation to give a recommendation, but if it does
so, it must similarly do so carefully. (For reasons stated below, I do not agree however
with AP that these duties arise out of the securities lending agents fiduciary
responsibilities.)
150. However, given the view I take on the facts, it may not be necessary to decide this. As I
describe later, once Sigma was downgraded from AAA in April 2008, and in particular
once the indicative price of the securities dropped sharply at the beginning of May,
exposing AP to an unrealised loss of US$10.5m, the bank decided to contact AP and other
clients about the position. It is not in dispute that it had to do so with all due care. APs
case is that it should have been contacted earlier. I discuss this issue later.
(4) The commingled fund and programme approach issues
(a) The issue
151. As I have described, AP chose a segregated account rather than entering one of BNYMs
commingled funds. The essence of its point in this respect is as follows. BNYM held a
large quantity of Sigma securities, and in allocating them to APs account, AP says that it
was treated as though it was in a commingled fund. This was because BNYM managed
its cash collateral investment on a programme approach, in other words across its whole
range of securities lending clients, instead of treating AP as an individual account. AP says
that clients such as itself did not expect to be treated as part of a much wider exposure to
securities as part of a "programme approach" or, in effect, as part of a commingled fund,
by reason of very large aggregate positions in securities held by the bank.
152. BNYM says that programme wide approach does not mean that BNYM took a decision
that all clients would be treated identically regardless of their investment guidelines. It did
mean that, insofar as clients were subject to the same investment considerations, there was
no reason for BNYM to differentiate between them. That is so whether or not BNYM
was subject to any legal duty to act fairly as between its clients, because it follows as a
matter of contract and common sense.
153. In its closing submissions, AP says that what was presented initially as a bank policy,
turned out to be nothing more than a resort to common-sense. There is force in that
comment, and this issue had less significance by the end of the trial than appeared at the
beginning.
(b) The facts as to the size of the banks Sigma holdings
154. After Sigma was approved as an issuer by Mellon Bank in 2005, it acquired a substantial
holding of its securities. By the time of the disputed purchases for AP in March/April
2007, its total aggregate holding of Sigma MTNs was approximately US$2.9 billion.
Taking APs calculations, this corresponded to nearly 6% of Sigmas total issued debt,
and 9.7% of its total US dollar MTNs issued at that time.
155. The two purchases for APs account at issue in these proceedings are:
(1) A purchase of Sigma MTNs maturing on 12 March 2009 acquired on 12 March
2007. The total amount purchased by the bank in this transaction was US$500m, of
which US$5.5m was allocated to APs account.
(2) A purchase of Sigma MTNs maturing on 30 October 2008 acquired on 26 or 30
April 2007 (the date of acquisition is in dispute). The banks total purchase in this
transaction was US$300m, which was the entire issue, of which US$30m was allocated to
APs account. I believe that these were the last Sigma MTNs bought by either Mellon or
BoNY.
156. The merger of Mellon with Bank of New York took effect on 1 July 2007. The latter also
had a substantial Sigma holding. The precise figures are hard to pin down, but at this time
the merged entitys combined holding of Sigma was about US$5.5 billion. Taking APs
calculations, this corresponded to just over 10% of Sigmas total issued debt, and about
16% of its total issued US dollar MTNs. APs case is that this was an enormous holding.
157. My findings in this regard are as follows. At the time the relevant Sigma MTNs were
purchased for AP in March/April 2007, Mellon Banks Sigma holding was already large,
but I accept Mr Tants evidence that it was within its guidelines. After the merger in July
2007, the combined holding of over 10% of Sigmas total debt was very large, and in
excess of the banks guidelines. The bank clearly would never have considered acquiring
such a large holding but for the merger.
158. Again however, I accept Mr Tants evidence that at the time of the merger this was not
expected to cause problems. BNYM restricted further purchases of Sigma until the
proportion could fall to below 10%, which was anticipated (I consider reasonably) to
happen as issues matured and were repaid. Despite all the problems that ensued,
maturities did continue to be met until September 2008.
159. There were no further purchases of Sigma by BNYM, and the onset of the credit crunch
was soon to bring Sigmas issuance to an end, which happened in October 2007. As to
the possibility of reducing its exposure further by disposing of its holding, I accept Mr
Richards evidence that thereafter it was highly unlikely that the whole of the banks
holding could have been disposed of, given the state of the market. As liquidity
deteriorated in 2008, and Sigmas position itself deteriorated, I am satisfied that the sale of
very large blocks would have become more and more difficult.
160. It is clear that the size of its Sigma holding taken together with the adverse market
conditions placed BNYM in an exposed position, and I reject any contention to the
contrary. In a 1 February 2008 email, Mr Ford, who was co-head of Securities Lending at
BNYM, and who had a way of describing home truths in plain language, referred to it as
the 5 billion dollar problem. The fact that BNYM would not have been able to dispose
of the bulk of its Sigma holding even had it wished to must have coloured its approach.
161. In fact, Mr Richards evidence suggests that Mellons holding in itself would have been
too big to have been disposed of in the market conditions that prevailed. It follows that the
problem existed on the basis of a holding of around 5%, which though large, was clearly
not excessive. Further, it is not in dispute that it was possible to dispose of smaller
tranches of the size of APs holding by sale or ratio trade by which Sigma bought debt
back in return for asset sales, and as I shall describe such transactions did take place. This
point does not therefore make much practical difference.
(c) What the contract required
162. AP notes that BNYM has argued that if it exited Sigma MTNs for AP, fairness to all note
holders required it to exit for everyone. Without expressing a conclusion on that point, I
accept APs submission that BNYM was bound to apply the Investment Guidelines
agreed in the SLAA regardless of the position of its other clients. I did not understand
BNYM to contend differently in its closing submissions.
163. However, the question arises as to what AP expected application of the Investment
Guidelines to involve, and whether it expected to be treated as one of a considerable
number of clients, both segregated and commingled, or in effect to be treated as a single
client in isolation.
(d) APs understanding of the position
164. I begin with a point about volume. After Sigma securities had been approved as an issuer,
Mr Servis suggested that BNYM should have imposed an initial maximum limit of in the
region of US$300 million on Sigma acquisitions across all its clients. In the context of
securities lending, I consider that this would be a very small amount. There is no basis in
the evidence for this suggestion, and I reject it. I accept the evidence of Mr Tant, who said
that US$300 million is the approximate size of a single purchase of Sigma notes.
There would be no purpose in approving Sigma with such a low limit.
165. This gives an indication of the size of transactions that BNYM carried out in its investment
function, a point also referred to by Mr Zimmerhansl in his evidence. Large purchases
allow the agent to obtain better prices. Once an investment has been made for a client in
accordance with its guidelines, the securities lending agent is able to manage it on a
common basis with other clients holding the same investment. BNYM says that AP must
have known this when it entered into the contract.
166. In fact, APs Investment Guidelines themselves recognised the large potential size even of
its own holdings. This clearly appears from section 4a), which provided that the greater of
US$100m or 3% of its account could be invested in the obligations of any one issuer.
167. AP accepted in opening that in order to get the best price for all clients, the lending agent as
discretionary investment manager may in practice purchase a block of securities and then
allocate these securities to those clients whose investment guidelines permit the purchase of
the security. However, it says, this is a matter of administrative convenience for the
manager to execute the securities transactions more efficiently, and should not impact in
any way on the monitoring or decision-making duties owed by the manager to individual
clients.
168. I do not accept that this reflects the evidence. The tender process sheds some light on the
issue. I have referred above to the response which BNYM sent to AP on 30 July 2004.
The document was put in cross-examination to Mr Grunditz, who was asked whether it
was not clear to him that the way that the bank was conducting its securities lending
programme was on a global basis, looking at issuers and issues for clients globally. His
answer appeared to acknowledge that it was. He said that, when I read the document,
yes, its true that they assess this on a global level, but what we signed was a discretionary
mandate.
169. He did not however assent to the proposition that there is no inconsistency between
looking at securities on a global basis, and a discretionary mandate for a particular account.
In fact, on the evidence I do not think that there is any inconsistency, given the nature of
securities lending.
170. It has to be kept in mind that at the time of the tendering process in 2004, AP was
contemplating making a considerable proportion of its entire portfolio (nearly a third)
available for lending. This led eventually to a potential pool of US$10 billion of AP
securities available for lending out. AP was examining four tenders for the custodianship/
securities lending role (which clearly went together) from leading market participants, and
had the assistance of an independent consultant. Having heard them give evidence, I am
satisfied that the relevant officers of AP are people who would have made it their business
to understand how the investment of cash collateral would be conducted in practice. Once
the contract was operational, they had daily reports which set out what collateral was being
held on their account.
171. I consider that BNYM is entitled to the findings of fact that it seeks in this respect. It must
have been obvious to AP in appointing BNYM as its securities lending agent that it would
be one of a considerable number of clients, both segregated and commingled. It cannot
have expected that BNYM would operate its account as if there were no other clients.
This reflects, in my view, the reality of securities lending business carried on for the
mutual convenience of financial institutions. Further, it must have been obvious to AP that
various aspects of its account management would be centralised. As BNYM says, one of
the main reasons for selecting a securities lending agent is for its investment expertise,
including in credit analysis of collateral, which would be expected to be shared across
clients. So far as it is to the contrary, I reject the evidence of Mr Cirrito on the point.
(5) Did the bank owe AP fiduciary duties?
172. It is common ground that BNYM owed AP a duty of care both under clause 10(b)(i) of
the Securities Lending Authorisation Agreement and in tort. The issue here considered is
whether AP is correct to argue that BNYM also owed it fiduciary duties. BNYM says it
is not.
173. A commercial banking relationship does not generally give rise to fiduciary duties (JP
Morgan Chase Bank v Springwell Navigation Corp [2008] EWHC 1186 (Comm) at
[573], Gloster J, Affd [2010] EWCA Civ 1221). But in relation to the duties of a global
custodian, entrusted with the safekeeping of its clients securities, and the duties of a
securities lending agent, entrusted with the lending out of the clients securities against
suitable collateral, a bank may in my view be subject to fiduciary duties in respect of those
activities (see generally Yates & Montagu, The Law of Global Custody, 4th ed, 2013).
These are the kind of activities in respect of which fiduciary duties are capable of arising
by virtue of their nature. In principle, therefore, I agree with AP that the relationship
between it and BNYM was capable of giving rise to fiduciary duties on the banks part.
174. But a party such as a securities lending agent may be in a fiduciary position as regards part
of its activities and not as regards other parts. The fact that BNYM may have been a
fiduciary in some respects does not mean that it was a fiduciary in all respects. The court
has to consider the particular duty alleged to be breached (Saltri III Ltd v MD Mezzanine
SA SICAR [2012] EWHC 3025 (Comm) [123], Eder J).
175. As a matter of fact, in some of the material in evidence BNYM expressly stated that it is
subject to fiduciary duties. At a marketing presentation in Stockholm on 28 May 2004,
BNYM (then the pre-merger ABN AMRO Mellon) explained its lending philosophy of
minimising risks to our clients by applying the appropriate risk parameters and
maintaining strict adherence to our fiduciary responsibilities. The responsible BNYM
officer did not shy away from this as a current statement in cross-examination. I have no
doubt that this reflects the nature of the bank as an institution with a global securities
lending business. Such a business has to run to similar standards wherever it is
conducted, particularly those of the United States where BNYM is based.
176. But it does not follow that because the term fiduciary is used in documentation, fiduciary
duties necessarily arise under English law. The term fiduciary is sometimes used to
describe a particular type of financial business (as in Germany or Switzerland), and where
it is used in a legal sense, as in common law jurisdictions, the term has somewhat different
connotations from jurisdiction to jurisdiction, albeit derived from the same roots in equity.
So far as English law is concerned, the essence of a fiduciary relationship is that the
fiduciary subordinates his own interests to those of his principals (Wollenberg v Casinos
Austria International Holding GMBH [2011] EWHC 103 (Ch) at [208], Lewison J).
177. In the English context, it has been said that the law relating to fiduciary duties in its
application to the financial sector and to the interrelationship of such duties and regulatory
duties is still in relative infancy (Jackson & Powell on Professional Liability (7th ed.) at
para 15-046). This may be because primacy is given to the contract. As was said in the
leading Australian case, the contract regulates the basic rights and liabilities of the parties
and the fiduciary relationship, if it is to exist at all, must accommodate itself to its terms
(Hospital Products Ltd v United States Surgical Corp (1984) 156 CLR 41 at 97, Mason
J).
178. This applies with particular force where the parties are both substantial financial
institutions dealing on an arms-length basis. The fact that an agency relationship existed
between BNYM as lending agent and AP as lender does not change the analysis (Kelly v
Cooper [1993] AC 205 at 213H-214A, Lord Browne-Wilkinson).
179. BNYM denies that it owed any fiduciary duties to AP, and contends that the terms of the
contractual relationship are inconsistent with such the existence of such duties. There is in
my view force in this point. Particular reference is made to clause 15(o) Global Custody
Agreement, clause 17(e) SLAA, and clause 7 SLAA. These appear to acknowledge that
conflicts of interest may arise, that BNYM was entitled to enter into transactions in which
it had an interest without making disclosure, and that the agreement did not impose an
obligation to lend APs securities in the event it made a loan of another clients securities.
(As I have said, although AP says that the GCA and SLAA were separate agreements,
they were linked.)
180. The parties did not agree as to how the law treats the relationship between a fiduciary duty
and a duty of care contractual or tortious. The case of Bristol & West Building Society v
Mothew [1998] Ch 1 is the leading authority in this respect. It concerned the liability of a
solicitor who had given negligent advice. He argued that while he had been negligent, he
had not been guilty of a breach of fiduciary duty. Upholding this submission, at page 18F
Millett LJ distinguished between them as follows:
The nature of the obligation determines the nature of the breach. The various
obligations of a fiduciary merely reflect different aspects of his core duties of loyalty
and fidelity. Breach of fiduciary obligation, therefore, connotes disloyalty or infidelity.
Mere incompetence is not enough. A servant who loyally does his incompetent best
for his master is not unfaithful and is not guilty of a breach of fiduciary duty.
181. As a matter of history, in this litigation APs claims were based on negligence, the claims
for breach of fiduciary duty being added by amendment shortly before trial. They were
based on Mr Cirittos expert report, but as BNYM says, the question whether it was a
fiduciary and if so what its fiduciary duties entailed, were matters of law for the court. The
main such claim was an allegation by AP that the size of BNYMs holdings of the Sigma
MTNs had the inevitable consequence of creating a conflict of interest because of the
increased probability that selling a position would impact negatively on the price of the
instruments across the programme. That was a true claim for breach of fiduciary duty, but
during the course of argument, that amendment was withdrawn by AP. Nothing that I
have heard during this trial suggests that this was anything other than the right decision.
The supposed conflict of interest would have made a securities lending operation
impossible.
182. What remains? To quote APs opening, BNYM owed fiduciary duties to it as a result of
the investment management discretion and/or the agency relationship and/or as
discretionary investment adviser in the management of APs Account under the SLAA (1)
to act at all times in APs best interests; (2) to treat AP fairly; (3) not to prefer any other
client to AP in circumstances where the situation called for equal treatment; and (4) to
bring any material information about APs investments to APs attention, and in particular
to give full disclosure of material information during the conversations during the
telephone and email conversations in May 2008 in relation to the matters relevant to the
Sigma MTNs in APs Account.
183. For reasons set out elsewhere, as regards duty (4) (the alleged duty of disclosure), I have
rejected the wide duty of disclosure which AP contends for. Otherwise, within the
parameters of the contract, none of these duties were in dispute. BNYM accepts that it had
to act in APs best interests, to treat it fairly (including in communicating with it about
Sigma in May 2008), and not to prefer other clients where the situation called for equal
treatment. The issue is whether BNYM complied on the facts of the case.
184. As it has been put, equity is proscriptive, not prescriptive. It tells the fiduciary what
he must not do. It does not tell him what he ought to do (Attorney General v Blake [1998]
Ch 439, 455E, Lord Woolf MR). BNYM submits that a fiduciary duty to act in a clients
best interests means that the fiduciary must avoid conflicts and must not make a secret
profit. Positive obligations are engaged only where the duty is breached. Thus a fiduciary
in a position of conflict must disclose it and seek consent from his principal, and one who
makes a secret profit must give an account and disgorge it. But, it says, those positive
obligations arise as remedies rather than standalone duties. I agree with this analysis.
185. My conclusion is as follows. In broad terms, the issues that arise in this case are whether
BNYM should have acquired Sigma securities for APs account, whether it should have
disposed of them when Sigma got into difficulties, and whether it presented the position
fairly when it contacted AP about the subject. There are of course other claims such as
breach of mandate, but those aside, I agree with BNYM that in substance what is at issue
is BNYMs competence as a securities lender. None of the breaches alleged by AP
involve any duty properly categorised as fiduciary. They are, in BNYMs words,
negligence claims dressed up in fiduciary garb. The fiduciary duty analysis adds nothing
in my view, and I do not accept APs submissions in that regard.
(6) The contractual standard of care
186. To recap, clause 10(b)(i) SLAA defines the standard of care required of BNYM as
lending agent. It has to perform its obligations under the agreement with the care, skill,
prudence and diligence which, under the circumstances then prevailing, a prudent person
acting in a like capacity and familiar with such matters would use in the conduct of an
enterprise of like character and with like aim. A number of disputes arose between the
parties as to the meaning of this provision.
187. AP submits that clause 10(b)(i) sets out the appropriately high standard of care attendant
upon a securities lending agent acting under an investment management discretion, i.e.
acting to invest monies prudently on behalf of another party with the fiduciary
responsibilities relating to protecting principal attendant upon that role. (As to fiduciary
responsibilities, I refer to the discussion above, but the submission is not dependent on the
banks position as fiduciary.)
188. As to whether AP is right to argue for a high standard of care, it submits that the addition
of the words prudence and diligence must connote a higher standard than had those
words not been included. In the context of securities lending, where clients such as AP
were told that the bank selected only those credits and investment opportunities that
provide a near certainty of full repayment of principal, and superior secondary market
liquidity, the word prudence connotes caution, in the sense of trusteeship.
189. The standards of prudence and diligence, AP submits, also connote a high level of
procedural care, requiring documented policies and procedures, and an emphasis on
regulatory compliance and compliance with market practice. As to this, I am satisfied from
the evidence and material disclosed that BNYMs procedures were adequately
documented. No separate point arises in this respect.
190. BNYM submits the standard of care imposed on BNYM under clause 10(b)(i) SLAA is
equivalent to the usual professional negligence standard of reasonable care and skill. In
particular, the use of the word prudent does not connote a higher standard, whether by
comparison to the standard of care owed by a trustee or otherwise. Further, the standard of
care required of BNYM is limited to taking reasonable care and skill in performing its
obligations under the SLAA, and cannot give rise to the additional obligations.
191. I have touched already on the last contention. Clause 10(b)(i) provides for the standard of
care to be observed by BNYM in performing its obligations under the agreement. BNYM
says that it does not in itself give rise to, as it was put, a raft of additional duties. I agree
that the clause cannot extend the ambit of BNYMs obligations as securities lending agent,
but in performing that role, BNYM had to meet the contractual standard of care. BNYM
accepts (for example) that the purchase of a permitted type of investment can be challenged
if the bank fails to use reasonable skill and care to select an appropriate asset of that type.
It accepts that in putting the Sigma risks to AP in May 2008 it was under a duty do so
fairly, though these points are not spelled out in the agreement. I do not think that anything
turns on this contention. So far as this case is concerned, if the bank falls short of the
contractual standard of care, liability results not by way of imposing additional obligations,
but of giving effect to the existing ones.
192. The main difference between the parties at trial was whether the clause imposed a high
standard or the usual standard of reasonable care. I doubt there is much difference of
substance between them. BNYM is the industry leader in securities lending, and it would
be surprising if it did not seek to uphold high standards in that role. In their evidence, its
witnesses stressed their commitment to client care and observing best practice.
193. As a matter of wording, AP has pointed out that the words of clause 10(b)(i) track the
language of the US Employee Retirement Income Security Act of 1974 (ERISA), a federal
law that sets minimum standards for pension and health plans. However, no particular
construction was advanced at trial based on this fact. My preference is for APs
contention, because BNYM was entrusted with lending out the portfolio of a pension fund
which had important public duties (see the similar point made in Bartlett v Barclays Bank
Trust Co Ltd (No 1) [1980] 2 WLR 430 at 534 by Brightman J). However, it makes no
difference to the outcome. I would have reached the same conclusion on either
interpretation.
(1) APS CLAIMS RELATING TO THE ACQUISITION OF THE SIGMA MTNs
Summary of APs case in relation to acquisition
194. There were two tranches of Sigma medium term notes acquired by BNYM for APs
account, being US$5.5m (maturing 12 March 2009) acquired on 12 March 2007, and US
$30m (maturing 30 October 2008) acquired on 26 or 30 April 2007 (the date of
acquisition being in dispute).
195. APs case in respect of acquisition as set out in one of the schedules attached to its closing
submissions is (in summary) that:
(1) The acquisition of the MTNs was in breach of mandate since it breached the
preservation of principal objective in the Investment Guidelines since the MTNs did
not have a near certainty of repayment.
(2) The MTNs were illiquid, and BNYM failed at acquisition to assess the suitability of
the MTNs against APs requirement not to be invested in illiquid securities, and failed
to assess their suitability at any stage during the period after acquisition and up to
default in October 2008.
(3) The MTNs were purchased pursuant to a deficient initial review by Ms Demmler.
(4) Mellon Bank lacked formal or documented internal concentration limits.
(5) The acquisition was in breach of mandate because the MTNs were illiquid or in so far
as it was part of a programme.
(6) The acquisition breached the 40% limit in the Guidelines.
(7) The acquisition breached the contractual duty of care in that the MTNs were not a
suitably conservative or liquid investment to comply with AP's key objective of
preserving principal.
(8) BNYM breached its fiduciary duties to the extent that APs tranche was part of a
programme, and BNYMs ability to monitor, manage and/or sell the securities was
fettered by AP being treated as part of a commingled fund.
(9) There was a breach of the Conduct of Business rules in that the purchase of the Sigma
MTNs as part of the programme of nearly US$3bn Sigma MTNs contravened
BNYMs duty of best execution to AP under COB 7.5.
APs case as to suitability
196. APs pleaded case is that the Sigma MTNs were not a suitably conservative investment for
APs portfolio, and were not an investment that would have been made by a prudent
person having regard to APs core objective and its low appetite for risk. This broadly
corresponds with APs issues (1) and (7) above and raises a number of questions. First,
what was APs appetite for risk, and in particular, was it a conservative securities lending
client as it has asserted? Second, were the Sigma MTNs a suitably conservative
investment as collateral for AP? Third, does suitability as a concept apply, given that
the parties had agreed detailed Investment Guidelines?
(1) Was AP a particularly conservative securities lending client?
197. In its opening submissions AP contended that, as BNYM knew from the tender process
and reflected in the contract, AP was a conservative and risk-averse securities lending
client. This was an important part of its case. It said that whether or not Sigma MTNs
were acceptable as collateral to securities lenders generally, they were not acceptable to AP.
In fact, it is not in dispute (as Mr Zimmerhansl put it) that participants in the business are
conservative. As BNYM expressed it, the issue on the pleadings and the evidence is
whether APs Investment Guidelines marked AP out as a particularly conservative
securities lending client. BNYMs case is that they did not, as shown by the wide range
of asset classes and ratings permissible for investment.
198. The evidence given by Mr Grunditz was to the effect that AP relied on BNYM to provide
it with draft guidelines that were appropriately conservative. The facts in this respect are as
follows. In the tender process which I have described above, the response of 17 May
2004 that BNYM sent to AP attached the investment guidelines for the Delaware-based
Mellon GSL Pennsylvania Fund for USD investments, in other words a commingled
fund. AP knew that it was a commingled fund, and had yet to decide whether to go that
route. It is not in dispute that AP had the opportunity to amend these guidelines if it
wanted to apply them to a segregated account. Mr Grunditz said that he read them, but that
he didn't have any views on adding or deleting anyone from there.
199. Although it did not in the event go into the Pennsylvania Fund, preferring a segregated
account, the investment guidelines which AP went on to adopt were much the same.
There were some changes, and in her statement, Ms Thomasson-Blomquist said that they
made the guidelines more conservative. This assertion requires careful appraisal.
200. The changes made reduced the weighted average maturity from 45 to 30 days, inserted a
limit of US$1.5bn on the cash collateral programme (which was removed in January
2005), and deleted money market funds as permitted investments. An overall limit of US
$7bn on lending was imposed, which was about 30% of APs total assets at the time (it
was increased to US$10bn in May 2007).
201. I agree with BNYM that so far as investments were concerned, the changes that AP made
went primarily to interest-rate risk, and not credit risk. This was something which Ms
Thomasson-Blomquist largely accepted in cross-examination. The deletion of money
market funds, which was the change made to permitted investments, also went to interest,
since they were relatively low yielding.
202. Further, as Ms Hammarlund accepted, the reason for the segregated account was not to do
with any supposed conservative appetite as regards investments. It was to protect AP in
the event of the failure of BNYM (in other words the institution holding the collateral).
There is no evidence that AP selected a segregated account because of concerns over the
credit risk of investments permitted in the commingled funds.
203. Further, although AP has emphasised that it was one of very few legacy Mellon clients
which had a complete restriction on illiquid securities, the restriction came from the
Pennsylvania Fund guidelines. It also has to be seen against the evidence of Mr Mannix,
who said that the banks practice was that it would not purchase any security unless it was
deemed liquid at the time of purchase. (He came from the BoNY side of the merger.)
204. APs witnesses suggest that it entered the SLAA in the expectation that so far as the cash
collateral reinvestment securities were concerned, there would be little risk to principal. I
accept that, and it is reflected in BNYMs material sent in the tender process quoted above
talking of preservation of principal, as well as safeguarding principal in the agreed
objectives. I am satisfied that AP had this expectation in common with all funds that
permit securities lending.
205. As to what the term safeguarding principal means, AP relied on certain bank documents
(and the comments of the witnesses on them) as showing that BNYM would select only
those investments which provided a near certainty of full principal repayment. An
example comes from the cross-examination of Mr Mannix, who agreed that the idea of
preservation of principal is that the investments that are purchased, at the time of purchase,
are deemed to represent a near certainty of payment. As Ms Demmler put it, were the
investments essentially what we call money good. Were they going to pay out at
maturity".
206. But as Mr Fort said, "Yes, the expectation is that there is little to no risk. Again, as I stated
earlier, it doesn't mean that there is a guarantee". AP criticised Mr Fort as a witness who
stonewalled, prevaricated and dissembled. I do not accept that, and consider him to have
been competent and professional (though as appears later I have not accepted part of his
evidence where it is inconsistent with the contemporary material). It is important in my
view to be clear that the use of phrases such as near certainty did not amount to a
guarantee by BNYM that the securities in which the cash collateral was invested would
never default, nor would they have been understood by prospective lenders as such. That
would have been a different transaction from the one the parties entered into. AP does not
suggest the contrary, but its emphasis on the language of near certainty of repayment at
times has come close.
207. As the banks presentation to AP in May 2004 put it, No lender would ever state they
offer an un-conservative cash collateral re-investment programme. But at the same time,
it is obviously not possible to achieve a return without risk. I am satisfied that AP was
fully aware that embarking on a programme that included for the first time the investment
of cash collateral was not a risk-free course of action. The truly conservative course was
to avoid securities lending altogether, or to avoid the reinvestment of cash collateral, either
of which courses was open to AP. Ms Hammarlund realised, she said, that its choice
meant more riskmore risk that is than in APs previous programme with Citibank.
208. In the schedule to its closing submissions, AP did not in the event invite any finding to the
effect that it was a particularly conservative and risk-averse securities lending client. I
would not have made such a finding. The evidence is that securities lending clients like
pension funds are conservative by nature, but there is no evidence that AP was any more
conservative than others. APs witnesses were clearly dedicated to the well-being of the
fund, but the fact is that they were prepared to lend out a substantial part of their portfolio
on terms which were not materially different from those of the commingled fund with
which they had been provided by the bank. They did so for what I infer is the same
reason that other funds enter into the activity, namely because it provided some extra
return, at a risk that was perceived to be low, but a risk nevertheless.
(2) Were the Sigma MTNs a suitably conservative investment as collateral?
209. AP maintains the Sigma MTNs were not a suitably conservative investment as collateral
for AP. In this respect, it relies principally on the evidence of Mr Servis. Among the
points he takes are that SIVs as a form of securities were among the most complex
structured finance vehicles ever devised. He draws attention to the fact that Sigmas
business model relied on it rolling over its debt in order to redeem existing liabilities. As
regards the underlying asset portfolio, he draws attention to the lack of transparency, and
the risk of subordination in relation to repurchase transactions. He also draws attention to
the vulnerability of the funding model, if a SIV were to lose its AAA rating. A further
point is that Sigma, unlike some other SIVs, lacked the support of a financial sponsor,
such as Citibank or HSBC.
210. Despite BNYMs submissions to the contrary, viewed from todays perspective, I
consider that most of these points are in substance correct. Although it is straightforward
to describe the basic model of a SIV such as Sigma, on analysis the package for an
investor was a complex one. The most obvious example concerns the terms of the Private
Placement Memorandum, and the nature of the right of recourse to the portfolio of assets,
as is shown by the difference of opinion in the courts about how Sigmas assets were to
be distributed after the appointment of the receivers (see Re Sigma Finance Corp [2009]
UKSC 2). (I do not however agree that SIVs were among the most complex structured
finance vehicles ever devised.)
211. Further, although the credit rating agencies apparently had CUSIP level information about
the securities in the portfolio (the CUSIP is the code which identifies a specific security),
investors acquiring Sigma MTNs only knew about asset classes. The Sigma MTNs and
this form of investment vehicle generally were (in substance) securities in securities, the
identity of which was unknown to the investor, and which themselves included securities
in securities, giving rise to a further level of non-transparency. They were, in a word,
opaque.
212. Further, the subordination of senior creditors to repo counterparties proved in the end to be
a major problem. Finally, I am satisfied that (as Mr Servis says) the model depended on
the AAA rating, partly to make it acceptable to investors like money market funds, and
partly because the AAA rating enabled Sigma to offer a comparatively low interest rate
upon which it founded its arbitrage. I doubt whether Sigma was especially vulnerable to
downgrades engendering a "cliff effect" plunging the security straight to junk, as AP
suggested. But it does not matter, because I accept the importance of the AAA rating to its
business model.
213. The ratings point merits some further attention. Mr Jonathan Dawid, junior counsel for
BNYM, took me through Moodys Rating Methodology for International Structured
Finance dated 28 January 2004, which is focused on SIVs as an asset class. The
Moodys model involves sophisticated mathematics, and as he pointed out, included a
scenario in which the SIV did not issue new debt, but was obliged to rely on its asset
portfolio to fund maturities. The implication was that if even the credit rating agencies
model did not predict a loss for investors on most scenarios, there was no reason to
criticise BNYM for having reached the same conclusion.
214. In that regard, BNYM also placed reliance on a Standard & Poors report of 12 September
2008, to the effect that it had considered five different scenarios, the first assuming a
continuation of Sigmas performance to date and the other four assuming progressively
more stressed environments. In the first three scenarios, S&Ps modelling found that
Sigmas MTNs would be repaid in full. The fourth predicted recoveries in excess of 90%
of par. Only the last, which involved Sigma selling assets at an accelerated rate to pay
debts before they fell due, involved a recovery of below 90%.
215. The tone of what is a brief report is positive (perhaps not surprisingly since, though the
ratings were lowered that day, they were still A ratings). AP makes various criticisms of
the methodology which I need not resolve. Suffice it to say that in my view, it is very
surprising that Sigma still had investment grade ratings at this time, since for reasons I
have explained elsewhere, by now it was hugely vulnerable. Lehman Brothers collapsed
three days after the report was published, but so much of its portfolio was tied up in repos
by now, that a much lesser shock would have been sufficient to cause its demise. This
report has no credibility in my view, and I do not think it carried any weight with BNYM
at the time.
216. Inevitably, the well-publicised flaws in the ratings given by the credit rating agencies as
laid bare by the financial crisis cast a shadow over the AAA rating given to structured
investment vehicles such as Sigma, and cast doubt on the mathematical models used to
justify them. Despite its submissions to the contrary, the evidence suggests that BNYM
itself lost faith in their reliability long before September 2008. A revealing email sent on
13 March 2008 by Mr Timothy Robison, who was the chief operational risk officer at
BNYM, and I infer not only senior but close to the market, says that, "The rating agencies
have been useless throughout this structured finance fiasco from the beginning. Nice to
see they are keeping that record intact." At that time, Sigma was still rated AAA, despite
the fact that it had been effectively defunct for months, and was using various techniques
to raise money on its assets to meet maturities as they fell due.
217. BNYM was certainly not alone in this view. At the beginning of April 2008, Sigma
finally lost its AAA status. A piece from an analyst at JP Morgan (who Ms Demmler
thought was usually pretty on-point) dated 7 April 2008 said that he thought that the late
downgrade of Sigma says much more about Moodys than it does about Sigma.
Investors were painfully aware of the problems, including reliance on repurchase
agreements: For many of them, the rating agencies lost credibility on this name long ago.
218. However, so far as APs claim relates to the purchase of the Sigma securities for its
account, the question is how matters looked in March/April 2007. AP cites a report
published by the FDIC in its Supervisory Insights on 30 May 2008, which says that Two
significant factors in the recent market turmoil have been the over-reliance on credit ratings
and a misunderstanding of what those ratings mean. But if, at the time of acquisition the
previous year and before the credit crunch blighted these securities, BNYM did place
over-reliance on the AAA rating, this report is an indication that it was in the company of
others in the market.
219. In fact, the evidence was that BNYM did not place exclusive reliance on the ratings. There
were other factors that recommended the issuer to BNYM as well. Sigma was the largest
single SIV, and was seen at the time to be particularly well run. BNYMs witnesses gave
evidence as to the standing of Sigma prior to the onset of the crisis. Mr Mannix described
it as a very popular investment, well respected in the market places and carried the
highest credit ratings. It was the most reliable SIV, as it was the largest and the oldest, and
had the right people running it. Ms Demmler, who was responsible primarily for Sigma
being added to the list of Approved Issuers, said that Sigma was well-known and highly
regarded. It was one of the most widely held programs in the market. Mr Ford said that
Sigma was perceived as the most successful and most highly regarded of any similar
entity because it was better capitalised, and more conservatively managed. Mr Fort said
that Sigma was one of the most well respected issuers in the market for securities
lending-enhanced cash investors. Mr Tant described Sigma as a well established
operator with a good track record.
220. These were experienced bank officers, I have heard them give evidence at some length,
and I accept it in this respect. As Mr Tant (who was head of the banks Credit Analyst
Group at the material time) said, he was aware that there were certain risk factors specific
to Sigma and SIVs generally in 2005they were buying longer duration assets and
arbitraging shorter duration funding. That he acknowledged created a certain risk element,
but it was also what created the return. This is, in my view, a fair description. He added
that in the case of Sigma, the way the vehicle was structured in terms of the capital and
liquidity and how those factors were managed was considered to be particularly robust.
Again, I accept this evidence.
221. It is borne out by the evidence as to the nature of the parties that were acquiring the
securities at this time. It is not in dispute that on the eve of the credit crunch, Sigma, and
SIVs generally, were widely held both by securities lending agents and by money market
funds. According to Mr Richards evidence, a 2005 report by JP Morgan identified that
70% of investors in SIV senior debt were money market funds, with another 20%
represented by securities lending cash collateral investments.
222. The defendant produced a schedule that suggested that at the time of Sigmas default, a
number of well known securities lending agents were still holding Sigma MTNs, and Mr
Fort gave evidence as to others. As described above, Mellon Bank added Sigma to its list
of Approved Issuers in 2005. It is also significant in my view that Bank of New York,
itself a major custodian, had independently approved Sigma for its securities lending
clients, and had acquired a large holding. APs case implies that both Mellon Bank and
Bank of New York were negligent at the time in approving Sigma.
223. AP appeared to accept that it is correct that many money market funds purchased Sigma
MTNs. It also, I think, accepted that they are conservative funds, since investors treat
them as a pool of liquidity, and it is essential that the net asset value (NAV) of the funds
does not fall below one dollar per share (known as breaking the buck).
224. AP gives a number of reasons why this does not show that the Sigma MTNs securities
were suitable for conservative investors. It points to the fact that the funds were permitted
to have 5% of their investments in illiquid securities, and that after the onset of the crisis,
sponsors entered into support agreements to ensure that investors did not suffer loses.
These points may be correct in themselves, but the fact is that money market funds
acquired large holdings of the SIV issues prior to the onset of the crisis. Mr Richard, who
makes this point, also says that Sigmas portfolio of assets was reputed to be of high
quality, diversified and contained minimal exposure to US sub-prime mortgage
securitisations.
225. The global financial crisis was a seismic event, and in judging investment decisions made
before its onset, it is important to avoid the benefit of hindsight. As BNYM says, the
indisputable fact is that Sigma MTNs were widely purchased and regarded by the market
as suitable instruments for cash collateral reinvestment. On the above evidence, I am
satisfied that at the time it acquired the Sigma MTNs for APs account, it was reasonable
for BNYM to consider the Sigma MTNs as investments appropriate for AP. Further, at
the time of acquisition, I find that these securities satisfied the safeguarding principal
objective in the Investment Guidelines.
(3) Does suitability apply, since the parties agreed Investment Guidelines?
226. For reasons given elsewhere, I have rejected APs breach of mandate case to the effect that
only investments which when purchased had a near certainty of payment were within the
mandate and objectives agreed.
227. However, in its written closings, BNYM sought to take its submissions in this regard one
step further, contending that these clauses define completely the level of credit risk which
AP was willing to accept. It submitted that the effect of the Investment Guidelines was
that BNYM is granted a discretion, with the extent of that discretion being delimited by the
guidelines.
228. In the course of argument on this point, Mr Ali Malek QC, leading counsel for AP, asked
hypothetically whether BNYM would have been entitled to buy Sigma MTNs in (for
example) early 2008, at which point they were still rated AAA, and fell within the
guidelines. The answer is obviously notby that time Sigma had ceased altogether to
issue new debt in the wake of the credit crunch. In its written submissions BNYM
accepted this, but on the basis that by early 2008, the securities had become illiquid, and so
fell outside the criteria in section 4h) of the Investment Guidelines which would have
applied to the notional acquisition.
229. This in my view is only a partial answer to APs hypothetical question. Even if the Sigma
securities had been technically liquid in early 2008, a prudent securities lending agent
would not have acquired them for the account of AP. A purchase might have been within
BNYMs authority, in the sense that the security complied with the guidelines, but
nonetheless have resulted in a contravention of the contractual standard of care in clause 10
(b)(i) SLAA. (This, it is to be emphasised, is an entirely different question to whether,
having properly acquired the securities, the bank should have sold them then, or could
legitimately have taken the view that it was better to continue to hold them to maturity. The
present discussion has to do with the banks duties on acquisition.)
230. In oral closing, Mr Mark Hapgood QC, leading counsel for BNYM, put the banks
contention differently. He submitted that if a type of security is within an asset class
expressly permitted by investment guidelines, there can be no argument about the
suitability of that asset type. In the present case, he says, any argument that SIV medium
term notes were unsuitable for APs portfolio is hopeless. The only ground on which the
purchase of a permitted type of investment can be challenged is if the bank fails to use
reasonable skill and care to select an appropriate asset of that type.
231. I agree with that submission. In the securities lending field, as in the case of other banking
activity, it is necessary to distinguish between a banks mandate, which defines the
authority given to it by its customer, and the standard of care which it must observe in
acting pursuant to that authority, whether arising under the terms of a contract, or in tort.
An acquisition of securities which falls within the parameters of the customers investment
guidelines is an authorised investment made in accordance with the banks mandate. As
asset-backed securities rated AAA, the Sigma MTNs fell into that category. It cannot be
challenged on grounds of lack of authority.
232. However, in making the investment, the bank remained subject to its duty of care, in this
case as defined in clause 10(b)(i) SLAA, which required it to perform its obligations as
Lending Agent with due care, skill, prudence and diligence. APs expert evidence made
general criticisms of SIVs as an asset class. But in agreement with BNYM, I do not think
that the duty of care can be invoked in support of an argument that SIVs as such were
unsuitable for AP. It had expressly mandated BNYM to acquire AAA asset backed
securities, and SIVs were such securities. The issue is whether there was some aspect of
the Sigma MTNs which made the acquisition of those particular securities a breach of
duty.
233. There is only one credible candidate in that respect. AP submitted that while some of the
SIVs were sponsored by banks, Sigma was not sponsored. The question arises
whether, on the basis of this distinction, the Sigma MTNs were unsuitable as collateral
albeit within the Investment Guidelines.
234. It is necessary to appreciate that bank sponsorship did not amount to a guarantee, and
there was at least one instance of a bank allowing its SIV to fail (Standard Chartered in the
case of Whistlejacket). However, Sigma was the largest single SIV, and was seen prior to
the onset of the crisis to be well run. So while I accept APs submission that the fact that it
did not have a bank sponsor was (contrary to BNYMs case) a disadvantage, I find that
the overall credibility of the issuer made up for that. This is demonstrated by the
widespread holdings of the Sigma securities which I have described above.
235. Further, the evidence is that it was perceived by the market that Sigma had an advantage in
that (unlike the SIVs that were taken over by their bank sponsors) it had no market value
or ratings-based enforcement triggers. These had been removed in 2003 in order to give
Sigma more flexibility to respond to difficult market conditions and avoid it being forced to
liquidate assets at distressed prices. This is one of a number of attributes cited by Mr
Richard which he says compare favourably with other issuers in the SIV sector. On the
evidence, I am satisfied that the lack of bank sponsorship did not make it unreasonable for
BNYM to consider the Sigma MTNs as investments appropriate for AP.
236. APs breach of mandate case has other limbs to it as follows.
Alleged breach of mandate to include AP in commingled/programme approach
237. AP says that to the extent that the acquisition of the Sigma MTNs was part of a
programme approach which in effect joined AP's investment in Sigma MTNs to the
aggregate position of all of the other securities lending clients of BNYM which held
Sigma MTNs, this was not authorised under the SLAA and was in breach of AP's key
objectives "to keep all cash collateral and related investments in a segregated account in the
name of [AP]" and "to safeguard principal".
238. I have dealt with the commingled fund /programme approach issue above, and refer to
what is said there. But given my conclusion that the Sigma MTNs were suitable
investments for AP, it does not matter whether they were allocated to its account applying
a programme approach. There was no breach of mandate and no negligence.
239. AP says separately that there was a breach of mandate in that BNYM had no authority
under the SLAA to include AP as effectively part of a "commingled" fund or programme
approach for purchase of Sigma MTNs as the aggregate position resulted in AP's Sigma
MTNs being "illiquid securities" within clause 4h) even if they were not when viewed in
isolation.
240. In my view, this is an artificial point. It is not in dispute that APs holding could have
been sold. In fact, this is a plank in APs second and third heads of claim. There was
never any question of selling BNYMs entire holding (or all of Mellons holding), even if
such a sale would have been possible. There is no basis for arguing that the securities
were illiquid within the meaning of the AP Investment Guidelines on this ground.
241. AP has an allied point, saying that there were no formal or documented internal
concentration limits applied by the Credit Analyst Group within Mellon Bank, and in this
the banks systems were seriously deficient. It says that had Mellon applied appropriate
concentration limits to the Sigma MTNs, from the date of the Initial Review (or the date on
which the Sigma MTNs were admitted to the Approved List) then the Sigma MTNs
would not have been purchased for APs Account at the dates of acquisition.
242. I reject this contention. I accept Mr Tants evidence that Mellon did apply an internal limit
10% of total issued debt, and the evidence of Mr Richard and Mr Zimmerhansl that this
was a reasonable limit. In substance, it was not in breach of that limit. As was put to Mr
Servis:
Q. And what happened on the merger was that the 10 per cent figure was
fractionally exceeded, and that was, in a sense, just an unavoidable consequence of
two banks each holding about 5 per cent merging
A. Okay, I accept that.
APs case that the Sigma MTNs were illiquid
243. A breach of mandate case is also based on the liquidity requirement in the Investment
Guidelines. Section 4h) of the guidelines provided that, The Account may not be
invested in illiquid securities. For the purposes hereof, an illiquid security is defined to be
an issue that is not sellable without the sale proceeds being materially impacted due to a
lack of other trading activity in the security. .
244. AP contends that the Sigma securities were illiquid, and that their acquisition on its account
was consequently in breach of mandate, and the banks contractual duty of care, given its
key objective of safeguarding principal. It also contends that BNYM failed to assess the
liquidity of the securities against the requirement in its guidelines.
245. In support, AP contends that as it and BNYM both understood at the time of the SLAA,
liquidity is a significant risk characteristic of an investment. The purpose of a prohibition
on illiquid investments in a conservative portfolio is to safeguard the capital in the account
by prohibiting the acquisition of securities which cannot easily and quickly be sold and
converted to cash without loss, particularly in times of market volatility and stress. An
investment is typically considered by the market to be a liquid security, AP says, if it is
able to be sold in the market at short notice and with minimal price impact (i.e. discount).
The importance of holding liquid investments is particularly acute in the context of
management of cash collateral accounts because of the well understood feature of the
industry that meant that there may be a need to liquidate, quickly, any position held in order
to return borrowed securities at short notice.
246. BNYMs case is that the Sigma MTNs were liquid securities, within the meaning of
section 4h) of the Investment Guidelines, at the time of purchase for AP in March and
April 2007. It accepts that the securities became illiquid following the onset of the credit
crunch later in the year.
The position as regards the liquidity of the Sigma MTNs on acquisition
247. I have described above the circumstances in which the Investment Guidelines were agreed,
and though AP says that it was one of very few legacy Mellon clients which had a
complete restriction on illiquid securities, there is no evidence that it placed any particular
emphasis on liquidity. The same provision was contained in the Mellon GSL
Pennsylvania Fund. Nor does it need to show such evidence. Unless the Sigma MTNs
satisfied the liquidity requirement at the time, their acquisition for APs account was a
breach of mandate.
248. So far as I am aware, the term illiquid securities has no fixed legal meaning. For present
purposes, what matters is the contractual definition in section 4h) of the Investment
Guidelines (see above). AP cited what I found to be a helpful comparison from the SEC
rules applying to money market funds, which in Rule 2a-7 define illiquid securities as
"securities that cannot be sold or disposed of in the ordinary course of business within
seven days at approximately the value ascribed to them by the money market fund". On
this basis, the idea behind the concept of liquidity in this context is not merely that the
securities can be disposed of, in the sense that there is a market for them, but that the price
on sale will approximate to their ascribed (or mark to market) value.
249. AP makes a number of points in support of its case, which I deal with below, but BNYM
makes a particular point, which it says, if correct, decides the issue. APs case, it says, is
based on the lack of a secondary market for Sigma MTNs. Whilst BNYM disputes that
there was such a lack, it submits that the size of the primary market for these securities at
the time of acquisition itself satisfies the liquidity requirement.
250. BNYM submits that prima facie evidence of such liquidity comes from the sheer amount
of Sigmas issuance, which in 2007 stood at some US$55 billion with a weighted-average
life of just over a year, meaning it was issuing debt at a rate of some US$50 billion per
year. This factual point is not as I understand it in dispute.
251. There was, therefore, BNYM submits, clearly an enormous demand for Sigma debt in the
market. While most of that demand would have been satisfied by new issues, from a
buyers perspective there is no distinction in terms of security or coupon between a newly
issued note and one offered on the secondary market, and it is common ground that the
same dealers acted both as primary placement agents and secondary market brokers. To
suggest that notes for which there was such demand in the marketplace were illiquid is, it
submits, absurd.
252. A number of points are raised by AP to displace this conclusion. Mr Cirritos evidence
was that the MTNs were illiquid, because they were private placements issued under
Securities & Exchange Commission Rule 144A. This is a rule that restricts certain
securities from being purchased other than by qualified institutional buyers (QIBs).
However, any support that this point may have given for APs case was lost when in
cross-examination Mr Servis did not agree with it. None of the other experts agreed with
it, and given the number and purchasing power of QIBs it is far from self evident that this
restriction reduces liquidity, and I do not accept it.
253. AP was on stronger ground in its submission that there was not an active secondary
market for the MTNs. Mr Richard identified five sales of Sigma MTNs by BNYM
between October 2006 and 30 April 2007 totalling US$544m executed at prices between
99.98 and 100.02 (in other words at par). In a second list, he identified 16 transactions
over the 2 years and 3 months between May 2005 and August 2007. BNYM also
disclosed bid lists relating to sales of Sigma MTNs in the period January-May 2007,
which show that when it sought to sell Sigma notes for clients in this period, it received
multiple bids close to or exceeding the original purchase price.
254. There was some significance in the latter point, because while other participants in the
market would not know the actual price agreed for the trade, they would see the cover,
i.e. the second-highest bid, which gave at least a degree of transparency to Sigma pricing.
However, in my view, although Mr Richard expressed the opinion that the secondary
market for Sigma securities was a liquid market, the figures he produced suggest that
Sigma MTNs were thinly albeit regularly traded on the secondary market.
255. I infer that this was because (as the evidence also showed) purchasers bought them to hold
to maturity. In fact, AP accepts (subject to its other submissions) that it might have been
a reasonable decision to acquire the Sigma MTNs in March and April 2007 on the basis of
a hold to maturity policy. These securities were not acquired with a view to secondary
trading. Such evidence as there is does however support the view that the securities were
sellable without the sale proceeds being materially impacted due to a lack of other trading
activity. That would mean that they were liquid within the contractual definition.
The position as regards the liquidity of the Sigma MTNs after acquisition
256. AP contends that the evidence shows that no-one assessed the suitability of AP's Sigma
MTNs position against its requirement not to be invested in illiquid securities under section
4h), either at acquisition, or at any stage during the period after acquisition and up to
default in October 2008. I do not agree with that contention. It is accepted by BNYM that
the liquidity of the MTNs was compromised because of the credit crunch. After that
happened, the status of the Sigma securities was (as I describe below) kept under close
review by BNYM.
257. AP also contends that the section 4h) restriction does not appear to have been coded in to
BNYM's systems as a restriction mandated by AP's guidelines. Instead, BNYM coded in
for all clients a minimum overnight liquidity of 20%. The four annual compliance reports
dated 28 February 2005, 31 January 2006, 31 January 2007 and 31 January 2008 show,
AP says, that BNYM had not coded anything into its systems for the section 4h)
restriction.
258. This contention may be factually correct, in that there is no mention of section 4h) in the
compliance reports. But this does not advance APs case, because I have concluded for
reasons set out above that the section 4h) restriction applied at the time of acquisition, but
not on a continuing basis. If anything, the fact that it was not coded in to BNYM's
systems tends to support that conclusion.
Conclusion as to liquidity
259. There is some support for the view that BNYM itself regarded SIVs generally as liquid in
March/April 2007, in the sense that the position changed at the onset of the credit crunch.
Slides of a Risk Committee Meeting held on 8 October 2007 under the heading Impact of
August/September 2007 Market Conditions stated, "Investments in SIVs, short duration
AAA rated MBS and ABCP declined in market value and became virtually illiquid.
260. On balance, I accept BNYMs case as to liquidity. Mr Richards evidence is that over the
period 20067, the amount of SIV debt issued increased very substantially. As I have
said, in retrospect, this can be seen as part of the bubble in asset-backed securities that
ultimately burst. However, there was plainly a strong demand for Sigma debt at the time
that BNYM acquired it for APs account. On balance, I agree with BNYM that the
strength of the primary market is sufficient to establish liquidity.
261. So far as the secondary market is concerned, I consider that the evidence justifies the
conclusion that had a holder sought to sell even substantial amounts of Sigma MTNs into
the market in March or April 2007, the sale proceeds would not have been materially
impacted due to a lack of other trading activity in the security. That is the liquidity
requirement as defined in the Investment Guidelines, and I consider that it was satisfied.
Even if Mr Servis is right to say that much of the secondary liquidity was supplied by
Sigma itself, this does not affect the conclusion.
262. While (as is clear from the slide I have quoted) BNYM accepts that the securities became
illiquid relatively shortly after acquisition, I find that this was because of the exceptional
conditions associated with the onset of the credit crunch.
APs case as to breach of the 40% FRN limit
263. The remaining limb of APs breach of mandate case is as to the limit of 40% placed on
investments in floating rate securities. Section 4e) of the Investment Guidelines provided
that No more than forty percent of the Account may be invested in floating rate
securities (such as floating rate notes or FRNs). The Sigma MTNs fell into this category.
264. APs case is that the acquisition of the US$30m Sigma MTNs maturing 30 October 2008
for APs account in April 2007 breached that requirement. For reasons I shall explain, the
issue depends on whether the notes were acquired on 26 April 2007 (as BNYM submits)
or 30 April 2007 (as AP submits). It is not in dispute that if AP is correct, the purchase
was in breach of mandate, and BNYM must make good APs losses in respect of the
notes.
265. The parties agree that the relevant date is the date of purchase of the AP Sigma MTNs for
AP. The banks total purchase in this transaction was US$300m. The purchase was made
via Lehman Brothers, and the trade ticket shows the date and time of the trade, namely 26
April 2007 at 16.56 pm. BNYM says, and I accept, that the trade details were incorrectly
entered on the banks systems, showing the counterparty as JP Morgan and the trade date
as 30 April 2007 and the time as 10.17 am. (The document also suggests that the issue
date was 30 April 2007.)
266. The documents AP relies on are as follows. The AP Holdings Report shows both
purchase and settlement dates as 30 April 2007. In the document allocating the securities
to AP and sixteen other clients, the settlement and trade dates are 30 April 2007. AP
submits that these are the documents that show the allocation and effective purchase date
for each of the clients to whom the US$300m bulk order was allocated. This shows
conclusively, AP says, that the securities were purchased for AP on 30 April 2007. The
trade ticket, it submits, concerns only the aggregate order.
267. The point depends on the total of floating rate securities in APs account on the two dates.
In this regard, BNYM says (and I do not think that this is in dispute) that on 26 April
2006 its total FRN concentration was 38.33%. Its total portfolio size at that time was US
$2.066bn. The impact on APs account of purchasing US$30m of Sigma MTNs was to
increase the total FRN concentration from 38.33% to 39.78%, which was within the 40%
limit.
268. What happened according to BNYM (again not I think disputed) is that by 30 April 2007,
the overall size of APs account had decreased slightly which resulted in the relative
proportion of FRNs increasing to 41.4% on that day. The nature of securities lending is
such, it says, that it is impossible to predict in advance what the size of a portfolio will be
on any day. That is because the amount of cash collateral to be invested is determined by
the value of securities that the client has on loan, and at any time a borrower may return a
security or the client may recall it. I accept this analysis as factually correct.
269. APs portfolio manager at the time (Mr Julian Anantarow who was based in Pittsburgh)
did not give evidence, but there was some explanatory evidence. Mr Mannix said that if a
security is appropriate, the relevant portfolio managers will have discussions regarding the
purchase of amounts for their portfolios. All of the orders are then combined, and one
large block order is placed with the entity that is offering the security. Once made, the
purchase is allocated across individual portfolios.
270. Mr Fort agreed, saying that the process at Mellon was fundamentally the same prior to the
merger with BoNY. The securities lending cash reinvestment team held a daily conference
call at about 8.30am every morning. During these calls, they discussed opportunities for
investments. Decisions as to what securities should be purchased would be made by the
entire securities lending cash reinvestment team jointly. Following the call, and again as a
team, they executed orders to buy securities and allocated these across the relevant
accounts.
271. Their evidence, therefore, is that the banks practice is to allocate securities at the time of
the purchase order. BNYM says that it would make no sense to put in an order for US
$300 million of securities without knowing in advance what could be allocated to each
client. There is in fact a manuscript note on one of the bulk purchase tickets which is
consistent with this evidence, but without explanation from the maker, who appears to
have been Mr Anantarow, I cannot give it any weight. However, in view of the other
evidence, I find that it is likely that the decision to allocate US$30m to AP took place at the
time of the bulk purchase on 26 April 2007, and not on 30 April 2007.
272. APs case is based on the allocation date as shown in the documents, and has considerable
force. But I consider that BNYMs case makes more commercial sense. This is a breach
of mandate claim, so that in effect absolute liability attaches to the bank if it gets it wrong.
The bank has to know at the time of the bulk purchase whether the amount it is
contemplating purchasing can be allocated among its clients, and this can only practically
be done by reference to the percentage limits as they are at that time. On the facts of the
present case, I consider that the date on which the MTNs were acquired and allocated to
APs account was the bulk purchase date, that is 26 April 2007, and that this was the
relevant date for the purpose of assessing compliance with section 4e) of the Investment
Guidelines. Accordingly I reject the asserted breach of mandate on this ground.
Alleged breach of duty of best execution
273. At trial, AP did not develop a late contention added by amendment that the purchase of the
Sigma MTNs for AP as part of the programme of nearly US$3bn Sigma MTNs
contravened the banks duty of best execution to AP under COB 7.5 in that the bank
would not, on its own case, be in a position to obtain the best price available for APs
tranche of US$35mm Sigma MTNs on a sale if those Sigma MTNs had to be sold as part
of a much larger US$3bn aggregate exposure.
274. It was right not to do so, since the point is not arguable. The duty of best execution has to
do with the mechanics of acquiring or selling securities, not the merits or otherwise of the
trade. APs contention is in effect a suitability point. As BNYM says, the duty of best
execution is a duty that, by definition, applies only on the execution of a client order. It has
nothing to do with the underlying investment decision.
Conclusion on acquisition claim
275. For reasons stated above and elsewhere in this judgment, I reject each of the components
of APs case. I do not consider that BNYM owed AP fiduciary duties, nor would it have
made any difference if it did. In summary, I find that there was nothing wrong with the
acquisition of the Sigma securities for APs account. They were seen as appropriate cash
collateral investments for securities lending programmes at the time, including for AP. The
problems emerged afterwards with the onset of the credit crunch.
(2) APS CLAIMS RELATING TO THE RETENTION OF THE SIGMA MTNs
Summary of APs case in relation to retention, and BNYMs response
276. APs case in respect of acquisition as set out in one of the schedules attached to its closing
submissions is (in summary) that:
(1) BNYM was obliged to monitor and manage APs account for compliance with the
objective of ensuring that the securities remained money good (i.e. with near
certainty of full principal repayment), and to ensure ongoing compliance with APs
investment guidelines.
(2) BNYM was obliged to provide full and open communication between it and AP as
soon as there was a problem with a security which threatened the near certainty of
repayment in full at maturity.
(3) By at latest the end of September 2007, the Sigma MTNs were no longer money
good and in addition, the Sigma MTNs were illiquid securities including within the
meaning of clause 4(h) and BNYM was obliged to do something in relation to the
Sigma MTNs for APtime was of the essence and BNYM could not do nothing to
manage this situation for AP.
(4) Exercising the care, skill, prudence and diligence required under clause 10(b)(i)
SLAA, meant that BNYM should have sold the MTNs by 30 September 2007, or 29
February 2008, or May 2008 or June to August 2008.
(5) Alternatively BNYM ought to have informed AP of the facts relating to the MTNs,
including the risk that there was a significant likelihood that Sigma would not continue
to be able to meet its commitments in respect of them, and that retaining them may lead
to a loss of capital, and recommended a sale or ratio trade.
(6) BNYM owed fiduciary duties to AP to act in its best interests, to treat it fairly, not to
prefer any other client to AP in circumstances where the situation called for equal
treatment and to bring any material information about APs investments to APs
attention, and it breached these fiduciary duties.
277. For reasons set out above, I have rejected submissions (1), (2) and (6). Those aside, the
essence of APs case is that BNYM should have sold the securities, or should have
informed AP as to the risk of default, and should not have preferred other clients over AP
in that regard.
278. BNYMs case is that it reasonably believed, at all times, that the most advantageous course
for clients such as AP was to continue to hold the Sigma MTNs, given that (i) the most
likely outcome was considered to be that the notes would be repaid in full; (ii) even in the
unlikely event of a default, analysis indicated that noteholders would recover at or close to
par; and (iii) the illiquidity of the credit markets meant that market prices available for
Sigma MTNs were well below that justified by the quality of Sigma's assets and the
expected recovery on the MTNs if held to maturity.
When should the securities have been sold, on APs case, and at what price?
279. Over the litigation, AP has put its case as to when the securities should have been sold in
different ways. The originally pleaded case was that the notes should not have been
retained after January 2008. At the beginning of the trial, there was some emphasis on the
view of Mr Servis that the sale should have happened when Citigroup bailed out its
comparable SIVs in December 2007. In oral closings, AP suggested that the sale should
have been in the autumn or late summer of 2007. In written closings it is said that, In
conclusion, AP contends that by January/February, it was clear that AP's Sigma notes
should have been sold. In the schedule to the closings, as I have said, AP seeks a finding
that BNYM should have sold the MTNs by 30 September 2007, or 29 February 2008, or
May 2008 or June to August 2008.
280. This issue as to timing raises the question as to what price APs Sigma MTNs could have
been sold at the various times which AP contends for. A useful document in this regard is
Schedule 2 to the Re-amended Particulars of Claim. This is a table showing a summary of
AP's best estimate of the prices for which its holding of Sigma MTNs could have been
sold in the period from August 2007 to September 2008. Although it is not formally
agreed, APs reliance on it was not challenged by BNYM, and I do not understand the
figures to be disputed. They were effectively endorsed by Mr Richard and I accept them.
(For the avoidance of doubt, it is not a contemporary document, but an extrapolation from
available data for trial purposes.)
281. It shows that while APs holding of securities could have been sold without an appreciable
loss on par (US$35.5m) up to 31 October 2007, thereafter the price declined showing a
loss of about US$11m by the end of April 2008. Thereafter the price recovered
considerably, before Sigmas final default in September. BNYM suggested that this was
because of returning confidence in Sigma. It is correct that there is some indication of
more bid activity, but the most likely cause in my view is that the risk was perceived to
decline the closer it got to maturity. The last available number is US$29,775,000 on 31
August 2008. It is common ground that prices would have been much lower had BNYM
sold (or tried to sell) its entire holdings (or much larger blocks) had that been possible at
all.
282. BNYM criticises what it says is APs failure to provide a comparator price, that is, what
AP contends would have been the expected recovery on the MTNs if held to maturity at
the various times at which it says they should have been disposed of. There is some force
in this, although expected recovery is something which the market would be expected to
price in, along with the possibility of default. But it does not arise as a major issue on the
facts as I have found them.
Credit monitoring
283. BNYMs closing submissions contain a useful analysis of the key metrics as regards the
Sigma MTNs as seen from BNYMs perspective. This highlights Sigmas monthly
business reports, the price available for Sigma MTNs on the market, and their ratings. On
the basis of such information, BNYM submits that a reasonable securities lending agent in
its position could properly have concluded that a sale at the depressed market prices being
offered (whether on a single client or programme-wide basis) would represent a worse
outcome than that expected from continuing to hold the securities.
284. It is to be noted however, that although he gave indicative prices, Mr Richards view was
that a sale on a programme-wide basis (in other words of BNYMs entire client holding or
even a large part of it) would have been impossible in the market conditions that prevailed
after the onset of the credit crunch. I accept that evidence, and reject BNYMs submission
that the fact it continued holding the Sigma MTNs, not only for AP, but for the vast
majority of clients is the strongest evidence there is that the Banks overall view, at all
times, was that the MTNs would be repaid in full. Its options in that regard were limited.
(i) Credit monitoring: APs case
285. A significant aspect of APs case is that BNYMs credit monitoring was defective. AP
says that the credit analysis carried out by the Credit Analyst Group (and Ms Demmler in
particular) was very limited indeed. Ms Demmler performed no liquidation analysis for
Sigma MTNs at any stage. Such credit analysis as was carried out did not make realistic
assumptions about key variables. This was because, AP says, the credit analysts did not
understand the impact of repo collateral leaving the Sigma vehicle, and was far below the
standard to be expected of a securities lender such as BNYM.
286. Had BNYMs credit analysts understood the impact of the repo financing, AP says, and
carried out a proper liquidation analysis using realistic assumptions for repo haircuts and
for mark to market prices on the Sigma underlying asset portfolio, and made reasonable
assumptions to consider what would happen if falling prices in the market caused repo
counterparties to trigger margin calls, the analysis would have shown risks of serious
losses given default (LGD) to Sigma MTN holders from May to September 2008.
(ii) The factual position as regards repo funding
287. The particular point made by AP, therefore, goes to the effect of the use by Sigma of repo
financing. I have noted above the increased use of repos as a source of funding after the
onset of the credit crunch. Based on the evidence of Mr Servis, which was itself based on
Sigmas monthly business reports, AP relied on modelling which was the subject of much
discussion at trial.
288. It is necessary in my view to look back at the position at the outset of the credit crunch.
Sigmas repo funding position stood at US$980 million as at 30 April 2007, which was
approximately 2% of its liabilities, in other words negligible. By 29 August 2008, the
position had altered completely, and Sigmas repo funding had reached US$17 billion,
which was approximately 60% of its liabilities. AP says that:
(1) As at 29 June 2007, the composition of Sigmas liabilities was 2.4% repos, 20.5%
commercial paper (CP), 70.1% MTNs and 6.9% capital notes.
(2) By 29 February 2008, the composition of Sigmas liabilities was 27.7% repos,
1.3% CP, 61% MTNs and 10% capital notes.
(3) By 30 May 2008, the composition of Sigmas liabilities was 40.3% repos, 0.4%
CP, 47.1% MTNs and 12.2% capital notes.
(4) By 29 August 2008, the composition of Sigmas liabilities was 60.5% repos, 0%
CP (it had all been repaid by this time), 25.4% MTNs and 25.4% capital notes (its
capital at book value had risen as a percentage of liabilities as debt was repaid at
maturity without new issuance).
289. I accept these figures, and though BNYM downplayed them, they show clearly how repos
expanded as a source of funding for Sigma over the relevant period. Some of BNYMs
witnesses referred to repos as a non-traditional source of funding, but that is not in my
view an apt description. Repos were used because access to funding via the CP and MTN
markets which Fitch in September 2007 had described as critical for SIVs to maintain
normal operations (see above) had dried up.
(iii) The nature of repos
290. In view of the way the argument progressed, it is necessary to say something about the
nature of repos, which is relevant in one particular respect. In simple terms, a repo is a
transaction in which one party sells an asset (such as fixed-income securities) to another
party at one price, and commits to repurchase the asset at a different price in the future.
Although a repo is structured legally as a sale and repurchase of the securities, it behaves
economically like a secured loan, with the securities acting as collateral (see e.g. DCC
Holdings (UK) Ltd v Revenue and Customs Commissioners [2011] 1 W.L.R. 44, SC; In
the Matter of Lehman Brothers International (Europe) (in Administration) [2010] EWHC
2914 (Ch) at [79], Briggs J; and the definition in Directive 2002/47/EC of 6 June 2002 on
financial collateral arrangements, Art 2).
291. The collateralisation is by way of haircuts/initial margins, which are usually set such that
the purchase price of a repo is less than the market value of the collateralthat is, they
typically result in over-collateralization. This is taken from a paper cited by BNYM,
Haircuts and initial margins in the repo market, European Repo Council, by Richard
Comotto, published by ICMA on 8 February 2012. (There is no need in the present
context to distinguish between haircuts and initial margins, and the parties did not do so in
their submissions.) At paragraph 3.6, the ICMA paper explains that on default, Any
excess collateral/cash remaining after the sale or purchase of collateral securities has made
whole the position of a non-defaulting party cannot be retained by that party and so does
not represent contingent additional compensation for bearing default risk.
292. In my view, as a matter of law the position as regards excess collateral in the case of a
default in a repo transaction depends, in the usual way, on the applicable terms, such as
those in the Global Master Repurchase Agreement (GMRA). But as a matter of
principle, I consider that BNYM is correct to submit that a repo counterparty is only
entitled to keep collateral to the value of its outstanding debt, and that any excess must be
returned. This is because the purpose of repo margin (like that of any security) is to
provide lenders with a means of repaying what is owed in the case of default, not to give
them a windfall profit. This point has consequences for the modelling performed by Mr
Servis, and relied on by AP, as I shall now explain.
(iv) The tables produced by Mr Servis
293. During the trial, considerable reliance was placed by AP on modelling produced by Mr
Servis in his supplemental report of 14 March 2013, in response to a supplemental report
produced by Mr Richard on credit monitoring. Partly on this basis, it was maintained that
BNYM had misunderstood the impact of the repo financing in the event of a default by
Sigma, and in particular did not appreciate the effect of repo haircuts. Taken at face value,
the tables showed the financial position deteriorating according to the size of the haircuts.
294. The evidence as to Sigmas repo position came mainly from the rating agency reports, and
did not contain much detail. I also consider that it is unclear whether the agencies relied on
information provided by Sigma, or had access to the agreements themselves. On 18
March 2008, S&P reported haircuts of between 2 and 10% as follows:
Since July 2007, Sigma has had to turn largely to the repurchase (repo) market to
refinance its debt maturities, and it now finances $11 billion of its asset portfolio
through those markets. These repo agreements, which have maturities between
three months and a year, enable Sigma to defer selling in current markets. Each repo
requires overcollateralization ranging from 2%-10%. These overcollateralization
levels could exhaust a large portion of Sigmas capital since they are posted away
from Sigma and in favour of the repo counterparties. If liquidity conditions worsen,
these additional margin posting requirements could cause Sigma to default in the
event of a missed collateral posting.
295. A higher figure of 12.4% can be calculated on the basis of Sigmas accounts to 30 April
2008, though BNYM points out that this is based on par, not market value. BNYM
emphasises that the Private Placement Memorandum stipulated (in effect) that initial
haircuts should not exceed 10%.
296. However that does not reflect what happened in practice. A report of 30 September 2008
says that Sigma told Moodys that the total notional amount of their assets was US$27bn,
with US$17.4bn of repo liabilities and overcollateralization of approximately US$8bn (US
$4bn initial margin and US$4bn variation margin). This indicates that haircuts in excess of
10% were being negotiated, and probably significantly so.
297. Whatever the size of the haircuts, Mr Servis assumes in calculating loss that, in a
liquidation scenario, repo counterparties would retain all of their pledged collateral,
including the haircut. However as noted above, any excess over the value of the loan
would have to be returned. His tables show that the value of assets available to meet
senior noteholders debts would reduce with each increase in haircut even though the
underlying asset price remains constant. As BNYM says, this cannot be right.
298. Mr Servis response was to the effect that in practice, repo counterparties have flexibility to
value the assets and will select a price so as to retain all the collateral pledged to them. That
is not in my view right either. Under the GMRA, the value of securities held as collateral
is required to be determined as the amount which, in the reasonable opinion of the Non-
Defaulting party, represents their fair market value. This is not in the counterpartys
discretion. (I add that I do not accept BNYMs further submission that the tables actually
support its case.)
(v) The effect of the repos
299. BNYMs case is that far from being a negative factor, as AP submits, Sigmas reliance on
repo financing was a positive factor. It seeks a finding that BNYM reasonably considered
that Sigmas ability to rely on repo financing was a benefit having regard to the long repo
terms and low margins being reported by the ratings agencies and the relatively short
maturities of the Sigma MTNs held by the bank.
300. I shall come to the evidence as to what the bank in fact thought about repos later. There are
some other points to deal with on the evidence first. As to the length of repo terms, the
passage from the S&P report of 18 March 2008 cited above refers to repo agreements
which have maturities of between three months and a year. To show that Sigma had in
fact negotiated long-term repos extending, for the most part, beyond the maturities of the
MTNs held for AP, BNYM relies on S&Ps report of 12 September 2008. This shows, it
says, that of Sigmas repo obligations, US$4.5bn fell due in the third and fourth quarters
of 2009, with further amounts maturing in 2010, 2011 and 2012.
301. The report makes clear that it was based on what Sigma had told S&P. It says that Sigma
was able consistently to extend repos with approaching maturities. But the numbers
mentioned for late maturing repos on which BNYM bases this point fall well short of
Sigmas repo liabilities, reported as US$17.4bn on 30 September 2008. BNYMs
contention is contested by AP, and I do not consider that it is proved. In any case, it is
common ground that with falling asset values, Sigma was at risk of margin calls, as
eventually happened.
302. In submissions by Ms Catherine Gibaud, junior counsel for AP, it summarises the effect
of the repo financing as follows. By August 2008, it was clear on Sigma's monthly
reports that the repo financing had reached US$17bnwhich BNYM accepts. Even with
a modest haircut of 15%, this meant, AP says, that the starting point for any credit analysis
should have been that US$20bn of assets had left the Sigma vehicle as repo counterparty
collateral. Broadly I accept this, and the general picture is in my view clear. (I should say
that I have placed no reliance on Appendix 3 to APs closings, which BNYM says does
not take account of a fall in outstanding MTNs.)
303. In its closing submissions, BNYM referred to an email sent to Mr Tant by Ms Saisselin of
Sigma on 18 September 2007, which suggested that not all the margin was in fact posted
to counterparties. This was not explored in the hearing, and while no doubt there will have
been variations in the terms of repo agreements, it is not in my view sufficient to alter the
picture as established on the rest of the evidence.
304. It is necessary to be clear as to what the repo transactions involved. A repo would enable
Sigma to repay maturing liabilities, without an outright sale of assets, but on the security of
the assets. The rating agencies considered that Sigma had managed this process well. For
example, all the outstanding commercial paper (which was short term) had been repaid by
July 2008. However, when the repo itself matured, unless Sigma was able to roll it over
(and it seems that Sigma had some success in rolling repos), the only source of repayment
was the assets. The process in effect bought Sigma time, in the hope that the market
would return to a pre-crisis position, enabling it to resume funding by issuing securities.
But it never did.
305. The fundamental point about the repos, in my judgment, is that they subordinated the
senior note holders like AP to the repo counterparties. This is not in dispute, and followed
from the terms of the Private Placement Memorandum, but was also inherent in the repo
transactions themselves which transferred the assets to the counterparties. Even if BNYM
is right that much of the repo lending extended beyond the maturity of APs MTNs, Sigma
was at risk of margin calls on a falling market. If it could not meet a call, the whole of its
repo exposure risked going into cross-default. This was in the event what happened, and
it was not in any sense unforeseeable in my view.
306. The result was, as AP says, that when Sigma failed, most of its assets went to repay the
repo counterparties. I reject BNYMs submission, therefore, that the repo transactions
were beneficial to AP. They were in my view very disadvantageous.
(vi) Discussion and conclusion on the credit monitoring issue
307. BNYM puts its case as follows. In hindsight, it says, following the failure of Lehman
Brothers and the subsequent collapse of asset values, it is easy to say that repos
represented a high risk and that Sigma should instead have focused on selling assets. But
absent foreknowledge of Lehman, BNYM says, it was plainly reasonable to anticipate that
marks on Sigmas assets would increase as they approached maturity. Long-term repo
represented an attractive option, because it avoided a need to sell assets at prices that
appeared to be temporarily depressed. Once prices had recovered sufficiently, Sigma
could either sell the assets and repay the repo, or re-repo them at a lower margin to par.
308. I agree that it is important to avoid hindsight, and there is evidence (which I accept) that
Sigma managed its repo-funding with some skill. But I do not accept that long-term repo
was an attractive option. Whether and if so when prices would recover was unknowable,
and Sigma was at risk of further falls prompting margin calls in the meantime. I agree with
AP that this did not depend on foreknowledge of the collapse of Lehman Brothers, which
in any case was a part of the crisis that came to a head in September and October of 2008.
309. AP criticises BNYM for not carrying out a liquidation analysis for Sigma MTNs at any
stage which considered the repo factor. In response, Mr Richard said that this would have
been impossible because BNYM had no access to the CUSIP details of the securities held
in Sigmas portfolio, despite asking for it. The frustration that this caused BNYM appears
from an email of 1 May 2008, in which Mr Robison said, "In terms of the overall recovery
value of our debt, as you know we have tried and failed many times to get the complete
listing of CUSIPS from Sigma that we would need to make such a determination. Without
that we would just be taking a guess".
310. Nevertheless, I agree with AP that BNYM does not appear adequately to have analysed
the impact of repos in a liquidation. Mr Ford maintained that BNYM thought that Sigmas
pay as you go enforcement procedures would be protective of short-term noteholders
such as AP. In the event, they were not, though BNYM says that was partly due to the
premature sales of assets pursuant to a misunderstanding by the lower courts in the Sigma
litigation of the effect of the relevant documentation.
311. I do not accept BNYMs case in this respect, because Mr Fords evidence is not supported
in the contemporary material. In any case, the effect of the repo transactions over time was
to reduce the remaining reason for confidence in the Sigma notes, namely their backing by
good quality assets. Further, I do not accept (as it submits) that it was reasonable for
BNYM to rely on the analyses of the rating agencies in this regard. I have referred above
to the email from Mr Robison, chief operational risk officer at BNYM, saying that, "The
rating agencies have been useless throughout this structured finance fiasco from the
beginning.
312. AP goes further, submitting that BNYMs officers did not understand the effect of the
repos. I doubt that this is the true picture. It is correct that there is some support for this in
some of the answers given in the Oklahoma depositions, but these were experienced
people who would have understood the general effect of Sigmas repo funding strategy.
313. I have dealt with the repo-financing issue in some detail, because it was an important area
of debate at trial. However though I have accepted many of APs submissions, overall I
do not think that it has a decisive impact on the points which I have to decide in this case.
In my view, the effect of repo funding is part of the overall factual picture.
314. Repos aside, I accept Mr Richards conclusion that BNYM monitored the condition of
Sigma closely as the financial crisis continued to worsen in a way that was reasonable in
the circumstances. In fact, there can be no doubt that it monitored it very closely indeed.
The contemporary material makes that clear. Further, I do not accept the recovery figures
proposed in APs closing submissions, which AP says a proper liquidation analysis
would have shown. These are based on Mr Servis tables which are flawed for reasons I
have stated.
Introduction to the 2007-2008 developments
315. I must now deal with the evidence as to what happened within BNYM as regards Sigma
during the period from August 2007 particularly up to May/June 2008, when AP itself
decided to hold on to the securities. I shall deal with this in periods, as AP did. AP says
that had its known and agreed investment objective been applied, its discretionary portfolio
would not have been exposed to the risk of failure of the Sigma MTNs. This part of the
case raises in particular the allegation that at some point BNYM should have sold the
MTNs, or at least ought to have informed AP of the risk before it finally did so in May
2008.
316. Both parties have given their own interpretation of the contemporary material, including
large numbers of internal BNYM emails. AP in particular relies on what is said in these
emails about Sigma in support of its case. In oral evidence Mr Tant (head of the Credit
Analyst Group at BNYM) pointed out that views within a financial institution may differ
about investments, and it is important that people should be able to express them openly. It
does not follow that what they say in emails represents the only available view of the
investment in question, or the view of the institution. I accept that general approach in
seeking to evaluate the material.
August to September 2007
317. I have set out the factual background above. What is striking in retrospect is how quickly
the loss of confidence in the financial system set in. As early as 5 September 2007 a
Moodys report said that:
SIVs in particular have to mark their portfolios to market, presenting difficulties
when, as currently, the market in question is not really functioning. As our
banking group stated in its global teleconference on 23 August, the blow to
confidence of the global financial system means that what was once liquid is now
illiquid, and good collateral cannot be sold or financed at anything approaching its
true value.
318. As I have explained above, another SIV rated AAA called Cheyne Finance went into
enforcement on 28 August 2007. From that time at the latest, I infer that Sigma was a
major concern for BNYM not least because of the size of its holding. However, the bank
also appears to have taken comfort from the distinction between Sigma and other SIVs,
since Sigma did not have market value or NAV-based enforcement triggers requiring it to
go into wind down on a drop in prices.
319. According to AP, the most important document showing why AP's exposure to Sigma
should have been eliminated in September 2007 is the presentation to BNYM's Risk
Committee attached to Mr Tant's email of 7 September 2007. I agree that it is an important
document, and it was circulated to senior management within the bank. However, the
parties are in disagreement as to what it shows. AP says that the presentation referred to
the strategy of reducing exposure to SIVs and recommended the continuation of this
strategy. What is critical, it says, is the analysis of the default risk for SIVs (including
Sigma) of "medium". AP should never have been exposed to a default risk of medium.
320. BNYM says that the reports recommendation was to retain on approved list more
established SIVs with strong sponsors and to continue to reduce to within limits
approved programs (i.e. to continue to allow the concentration to reduce to below 10%
through maturities). There was a recommendation in the report that BNYM Actively
seek opportunities to reduce Restricted SIVs while minimizing loss impact on clients,
but this was not a reference to Sigma.
321. BNYM correctly paraphrases the recommendation in my view. In distinction to
Restricted SIVs, Sigma was bracketed with more established SIVs with strong
sponsors. BNYM says that in describing the default risk of SIVs as medium, the
report was referring to the SIV sector as a whole, rather than to Sigma specifically. Again,
I agree with that interpretation, and it was supported by the oral evidence of Mr Tant.
322. Overall, the presentation appears to give a fair view of the sector as reasonably seen by
BNYM at the time. There was no recommendation to sell in the case of Sigma, as
opposed to some of the other SIVs, and so far as I am aware this did not happen at this
time.
323. AP cites a number of reasons why its Sigma holding should nevertheless have been sold
at this stage. First, it says that a person whose objective is to safeguard principal takes a
very small hit and cuts his losses. However, I reject this. There was no good reason to
take a small hit at this stage. For reasons explained, I have rejected APs case that it was
more conservative in its investment approach than other securities lenders.
324. Second, AP says that Sigma was at that stage proposing that BNYM enter into a trade to
reduce its exposure to Sigma. However, the evidence shows that the bank considered this,
but it rejected it on grounds that were reasonable. Third, it says that while a hold to
maturity policy might have been reasonable at the time of acquisition, there was no reason
to follow it in September 2007. However, I accept BNYMs evidence to the contrary,
because at this time it was reasonably anticipated that the notes would be paid in full.
Fourth, AP says that it should have been informed of any concerns relating to its
investment. I reject that submission as well for reasons which are essentially the same as
the above.
325. I am satisfied that BNYM was under no duty to dispose of APs Sigma holding at this
point in time, whether under its duty of care, or under the investment guidelines, or
otherwise. It had no way of knowing that the crisis was going to deepen. In his evidence
Mr Tant said that the market expected things to normalise in 2008: the biggest concern
in the fourth quarter of 2007 by all the players in the marketplace was just get us into
the first quarter 2008, things will normalise".
326. Further, the crisis caused problems right across the financial market. As investment
professionals, AP would itself have been aware of the situation. It does not appear,
however, that it took any particular steps to scrutinise the securities which were being held
on its account in place of that part of its portfolio that had been loaned out.
October 2007 to February 2008
(i) October to December 2007
327. As noted above, by the end of October 2007, Sigma had stopped issuing MTNs. On 26
November 2007, HSBC announced that it was bailing out its SIVs. On 13 December
2007, following a reduction in their capital NAV to below or near 6o%, Citigroup decided
to consolidate its SIVs on to its balance sheet.
328. According to BNYM, the latter development was regarded as good news, because of the
banks very large exposure to the Citigroup SIVs. I do not, however, accept its
submission that because it meant that there would be less competition for liquidity in the
marketplace, it was also positive news for Sigma. AP did not press in closing the view
expressed by Mr Servis in his report that this was the moment to eliminate, wherever
possible, all exposure to independent SIVs.
329. The evidence of Mr Tant and Ms Demmler is that they were comfortable with Sigma as an
investment at this time. This has some support in the contemporary material. When asked
by the Managing Director of BNYM Asset Servicing why the bank continued to feel
good about Sigma, Mr Tant responded by email of 19 December 2007 that, Sigma
continues to have strongest capital position of any SIV and has considerable capital
cushion. They are working on deal to strengthen funding profile but according to
Sigma the banks keep going back into a huddle. Asset quality is solid and suffered no
material downgrades.
330. At year end 2007, unlike some other SIVS, Sigmas ratings had not been downgraded. It
had however been placed by Standard & Poors on Negative Outlook. The Wachovia
Securities article dated 18 December 2007 I referred to above seems to me to reflect
perceptions as at the end of 2007 so far as the evidence in this case is concerned. It said
that Even though Sigma Finance is the largest question mark on the street, it remains one
of the strongest as well, with a Net Asset Value of capital at November month-end of
approximately 79. BNYM says that this means that Sigmas assets were sufficient to
repay all its senior debt (which included AP) and 79% of its capital notes.
(ii) The beginning of 2008
331. The evidence suggests that in early 2008, the view about Sigma became distinctly less
sanguine. One reason for the change in sentiment may be that in October 2007, Citigroup,
Bank of America, and JP Morgan Chase had announced an attempt to raise a US$100bn
superfund, which was known as the Master Liquidity Enhancement Conduit or M-LEC,
to help support the orderly unwinding of many SIVs. On 7 January 2008, it was reported
that M-LEC would not be launched after all.
332. Whatever the reason, this change is demonstrated in what Ms Falchetti of Standish called a
dramatic change in Sigmas responses. In a report which she prepared in February
2008, she says that, of all SIVs in business at the start of 2007, Sigma is the oldest and
has always enjoyed a reputation of being managed very well and holding high quality
assets. Sigma is the only non-bank sponsored SIV in which Standish has invested.
333. However, she goes on to refer to numerous conversations with Sigma since the start of the
SIV crisis. She notes that Gordian Knot (the manager) considered that funding problems
were a temporary condition, and that all discussions with them up until 15 January 2008
were relatively reassuring. Following its decision to take its own SIVs on to its balance
sheet however, Citi apparently walked away from its efforts to help Sigma. (This was
presumably a reference to M-LEC.)
334. Ms Falchetti then describes calls which she had with Sigma at the end of December, and
then on 15 January 2008:
"When I spoke with the Gordian Knot investor rep at the end of December, I asked
her how long Sigma could limp along and was told they could do so for a year.
When I called her on January 15th, the answers had changed dramatically. I began
by recalling our prior conversation and reminded her that she said Sigma could get
by for another year. I noted that we had a March 2009 maturity and asked her if that
was going to be repaid. The answer was "Your guess is as good as mine."
335. The "your guess is as good as mine" remark is of relevance, since the US$5.5m tranche of
APs MTNs also had a March 2009 maturity. AP says that it is the clearest of evidence of
a belief by Gordian Knot that there was a significant risk that the Sigma MTNs maturing
in March 2009 would not be paid on maturity.
336. The report goes on to say that Gordian Knot is now scrambling to find additional repo
counter parties. It says that an ad hoc creditor group had been formed, including BNYM.
Once May maturities hit, Sigma has the potential to go into enforcement.
337. In meeting this report, BNYM has emphasised the operational independence of Standish.
However, the evidence shows considerable contact between Standish and securities
lending. Ms Falchettis report itself includes details of its holdings, together with
maturities, which securities lending are said to have provided. In any case, it seems
unlikely that two arms of the bank would have taken a different view on such a large and
potentially risky exposure.
338. Although it is not suggested that Mr Tant or Mr Fort saw this report, it appears that Mr
Tant was in on Ms Falchettis call with Sigma of 15 January 2008. He certainly spoke to
Ms Saisselin of Sigma himself and reported it to Mr Robison (who was the banks chief
risk officer on the reinvestment side) the next day.
339. In fact there is a chain of emails. On 15 January 2008, Mr Robison says of the Sigma
notes They should be OK until at least May and June when the last of the ICR fund
debt matures. I would be more worried if we had late 2008 or 2009 paper here. Late
2008 or 2009 paper was of course what AP held. BNYM says that the concern related to
the risk of a mark-down or downgrade of Sigma MTNs, rather than a risk of loss on
maturity, but I do not accept that interpretation.
340. The ICR (Institutional Cash Reserve) fund referred to here was the liquidity vehicle for the
legacy BoNY segregated account clients. As such, it had to be able to operate at a dollar
in, a dollar out. This meant that the NAV of the fund had to be maintained above the
0.9975 threshold, which made it susceptible to fluctuations in the value of its underlying
assets. It had a holding of Sigma securities of more than US$500m, the last of which, as
Mr Robisons email indicates, matured in May/June 2008. It is clear from this and other
material that the potential effect of Sigma on the ICR fund was of particular concern to the
bank, including Mr Tom Ford who himself came from the BoNY side of the business.
341. In his response to Mr Robison of 16 January 2008, Mr Tant reporting on the conversation
with Gordian Knot said that Juliette [Saisselin] let the air out of the balloon in terms of
potential fixes near term, rather indicating that they are casting far and wide to look for
more repo availability. No ceiling on repo, however I suggested it is not a long term
fix. For reasons explained above, he was right that repos were not a long term fix. He
went on, what is plan B if markets dont normalise. They are not ready to have that
discussion at least publicly.
342. BNYM says that nothing in this undermines Mr Tants evidence of his view as to Sigmas
unlikelihood of default. I do not accept that. Nor do I accept that, as BNYM puts it, the
fact that Fitch stopped rating Sigma at the end of January 2008 was a complete non-
event. (The explanation appears to be that Gordian Knot had not renewed its contract
with Fitch and would not continue to provide it with information on Sigma.) There were
negative signs in the market by now. Asked whether there were any offers to buy Sigma
paper, Mr Mannix reported on 30 January 2008, The only indication we got from the
Street was at 75. This of course was far below par.
343. A meeting was arranged between the bank and Gordian Knot for 4 February 2008.
BNYM says, and I accept, that Mr Ford, who was Co-Head with Ms Kathy Rulong of
the Securities Lending Group, was keen to ensure that the bank was as well prepared as
possible. On 31 January 2008, he emailed Mr James Palermo, who is a Vice-Chairman of
the bank, saying, We have a senior level meeting on Monday with the management of a
AAA-rated, independently managed SIV called Sigma which we believe may be moving
closer to default because of current market conditions and the difficulty it is currently
experiencing in funding itself. Mr Ford added that he thought that it would be a good
idea for senior officers to discuss the client implications with him.
344. BNYMs submission (and indeed Mr Fords evidence) is that this email did not reflect an
actual belief that Sigma would default, but rather a concern about what he might be told by
Gordian Knot in the meeting. I reject this submission. Mr Tant said that he was being
overly dramatic, but I reject that too. The email was to one of the top people in the bank,
would have been carefully drafted, and speaks for itself. Any doubt is dispelled by some
late disclosure in the form of another email that Mr Ford sent to Ms Rulong the same day:
I'm hoping against hope, he said, that we can do something to reduce our positions
before its [Sigmas] demise.
345. Contrary to BNYMs case, I consider that this is what he thought at the time. Mr Ford
retired in June 2008, though he continued to assist the bank on various matters. He was
clearly a loyal as well as a respected officer. I have little doubt that he declined to come to
London to give his evidence, giving it instead from New York over the video link for an
afternoon only, because he realised that he would be unable sensibly to sustain the banks
interpretation of these emails in cross-examination.
346. I was not taken to a note of the meeting of 4 February 2008, but it is not in dispute that the
bank was unable to persuade Gordian Knot to provide CUSIP level of the Sigma
portfolio. However, according to Mr Fords witness statement, I recall leaving the
meeting satisfied with Sigmas financing strategy. According to his witness statement, he
was 90% confident that the notes would be paid at maturity.
347. Again this assertion of confidence made in his witness statement for this trial has to be
measured against the contemporary material. The bank was discussing with Sigma the
possibility of a deal which would take the ICR fund out of its May/June Sigma holdings
by way of a repo transaction. There were some difficulties with this, but Mr Ford said in
an email of 7 February 2008 that, i'd like to reiterate my interest in getting something done
because i continue to believe our unsecured notes may ultimately represent a risk level of at
least 15% of their face value and the repo transactions [with Sigma] represent less [risk].
348. BNYM says that this simply reflects the particular importance of maintaining the value of
the ICR fund. That may have been the motivation, but I am satisfied that it makes no
difference to Mr Fords view of the Sigma securities. As AP points out, not only does
this email foresee a risk of loss on Sigma holdings, but the risk of loss on APs holdings
which unlike those of the ICR fund did not mature until October 2008 and March 2009
would likely be higher.
349. On 21 February 2008, a client which had itself made contact with BNYM required it to
sell its holding of US$6m at a loss of US$1m, which (Mr Mannix said) suggested a price
of about 85. Mr Ford says that this represented a loss of about 20%. In an email at the
time, he said that he would sell [Sigma] to whoever was buying. At about this time Mr
Fort reported that they had sold Mellon Capital mutual fund's US$27m Sigma bonds
maturing on 12 March 2009 at 87.5. On 12 March 2008, BNYM sold US$53m maturing
15 September 2008 at 89 on behalf of a client.
350. Given this evidence, AP submits that BNYM was at fault in reporting in its holding
reports to AP near-par prices for Sigma MTNs in the period up to 30 April 2008 when it
knew, from its own experience, that market prices were well below this.
351. This submission is a substantial one, and my view is as follows. These securities were not
exchange-traded, and as indicated above, the secondary market was thin. A pricing source
was necessary not only for reporting to the client, but to enable BNYM to mark the
securities to market. Since securities lending agents generally acquire collateral on a hold
to maturity basis, actual market transactions might not happen at all. For this reason,
BNYM relied on an independent pricing vendor, IDC.
352. The position was clearly disclosed to AP in the holding reports:
Prices of securities reported herein are provided by pricing vendors and rating
agencies (pricing vendors) used by The Bank of New York Mellon (BNYM) in
the ordinary course of business. Such prices are not independently verified by
BNYM. Some reported prices are not updated by pricing vendors on a regular basis
(and therefore are considered stale) and in some cases, pricing vendors do not
provide prices. For securities where BNY Mellon's pricing vendors do not provide
prices, BNYM may use prices (which may be indicative bids) provided by one or
more dealers in such securities or by the Depository Trust Company or other
security depository (generally par value or the price paid on the last trade settled
through such depository) until such time that BNYM's pricing vendor provides
prices.
353. There was also a disclaimer of liability by BNYM. Though the above evidence shows that
the IDC pricing (like the ratings) lagged the market, I am satisfied that using a pricing
vendor was normal and reasonable practice. Despite sales which achieved much less than
par, I consider that BNYM acted reasonably in continuing to report the IDC prices at this
time. What eventually prompted BNYM to contact AP about Sigma was a sharp drop in
the IDC pricing in April 2008.
354. Although Mr Ford and Mr Tant suggested that BNYM had continuing confidence in
Gordian Knot (i.e. Sigmas management), again this is inconsistent with the contemporary
material. An email of 17 February 2008 shows Ms Rulong telling Mr Ford about a
meeting of Sigma investors, who were "very concerned about the arrogance of SIGMA's
management and that they were not doing enough. that they cannot continue to protect
their capital note holders from losses there is also considerable concern about the rating
agencies and possible imminent downgrades.
(iii) The end of February 2008
355. On 13 February 2008, Mr Mannix reported that S&P refused to sanction the proposed
repo deal with the ICR fund, which was also AAA rated. He said that S&P "decided that
it would be inappropriate to increase exposure to a distressed issuer, and as a SIV it would
be considered distressed". Mr Mannix said that S&P might revisit the repo proposal if
Sigma would agree a 150% margin with BNYM. (This margin may be compared with
those discussed earlier in this judgment.) There is other evidence to the effect that Sigma
was at this time dealt with by the distressed desks of securities traders, and I agree with
AP that this is significant as showing the market view. In the end, the proposed ICR deal
with Sigma came to nothing.
356. Sigma continued to be AAA rated at this time. Moodys put it on review for downgrade
on 27 February 2008, indicating that it was considering a downgrade to the AA range.
However, overall it remained positive, stating that:
The companys portfolio is of high credit quality, with 45% Aaa-rated, 43% Aa-
rated, 9% A rated, 2% Baa rated, and 1% rated Ba-B. The company has limited
exposure to ABS CDO and monoline wraps, and has no direct exposure to US
subprime RMBS.
Since mid-2007, the company has had limited access to the commercial paper and
medium-term note markets. However, the company has successfully tapped
alternative funding sources such as repurchase agreements (over $22 billion
transacted since July 2007), asset for debt exchanges, opportunistic debt buy-backs
and asset liquidations. The notional value of the companys asset portfolio declined
from USD 57 billion on July 27, 2007 to USD 41 billion on February 15, 2008,
reducing the companys leverage from over 13 times to approximately 9 times.
Despite these positives, the overall market price deterioration, continued inability to
issue senior, and reliance on repos have increased the companys risk profile. Asset
prices have continued their unprecedented decline. The average price was 100.2% of
par on July 27, 2007, and was 96.99% on Feb 15, 2008. To date assets have been
liquidated close to their marks.
357. Sigmas monthly report for the end of February 2008 showed that by that date, the par
value of its asset portfolio was US$39.2 billion. According to BNYM, based on an asset
price of 96.99, that implies a market value of US$38 billion, compared to outstanding debt
of US$36.1 billion.
358. The report seems to have given some reassurance to Mr Ford. This is demonstrated by an
email to Mr Tant of 7 March 2008:
whenever I see this monthly report I get a sense of higher, not lower confidence
about sigma. obviously the program is 4 billion smaller (feb vs jan); with capital
roughly the same (-21 million). a major portion of the portfolio decline ($2.9 billion)
seems to be the liquidation of 2-5 year assets, generally from the ugliest categories
mbs/clo&cbos/other abs. while they lost 1.1 billion of short maturities (0-1 year);
that doesnt seem so surprising under the circumstances. do you see it similarly, or
do you think Ive got my rose-colored glasses?
A reply email (if there was one) is not in evidence, though Mr Ford says that so far as he
can recall, Mr Tant did agree. Mr Tant says that the email is consistent with his general
thinking at this time.
359. On 18 March 2008, Sigma issued its quarterly report setting out its results to 31 January
2008, which were confirmed by its auditors, PwC. Page 5 of the report included a
statement that The directors, having taken into account market considerations subsequent
to 31st January 2008, still expect sufficient funding to be made available to Sigma for the
next 12 months.
(iv) Conclusions for the period January to February 2008
360. AP contends that by January/February, it was clear that AP's Sigma notes should have
been sold. It says that it is clear that the notes were wholly inappropriate having regard to
AP's investment objectives. Prudent practice also required BNYM to speak to AP about
its investments (in other words well before it did so on 16/19 May 2008).
361. BNYM says that the end February monthly report shows that for all the concerns being
expressed at the time, Sigma remained a strong and well-financed entity. It considered the
situation carefully, reaching out both to Sigma and to other creditors. The fact that it did
not sell out of Sigma at prices well below those justified by Sigmas assets is no grounds
for criticism.
362. As I have explained, I consider that perceptions of Sigma took a turn for the worse at the
beginning of 2008. On the other hand, securities lending client sales at this time (there
were only one or two) seem to have been at the clients initiative. An underlying issue was
whether the strength of Sigmas asset portfolio meant that the securities could be held to
maturity with a reasonable prospect of repayment in full for the senior noteholders. Mr
Tant says that this was his view at this time. Mr Ford clearly did not agree, but by the end
of February 2008, even his perception of Sigma appears to have improved (that was not to
last).
363. The banks witnesses are entitled to be judged on the basis of what they knew at the time,
and on balance I consider that BNYM is right to submit that there was no obligation on it
to sell APs Sigma notes, whether under its duty of care, or under the Investment
Guidelines, or otherwise, at this time. A ratio trade would have got rid of the Sigma
holding without an immediate loss, but it would have involved AP very substantially
increasing its overall market exposure, even assuming the trade could be done within its
guidelines (which BNYM disputes).
364. It is important to appreciate, as I explain later, that in practice such transactions would not
have been performed by BNYM without consulting AP first and getting its consent. In
reality, this is the prior question, therefore. As a matter of fact, BNYM was not contacting
its clients about Sigma at this time. I accept that AP has an arguable case that by now this
duty had arisen. On the other hand, this was a difficult exercise, as it proved to be when it
was eventually done. It ultimately was a judgmental matter for the bank whether to do so
at this point. Matters were soon to change, but on balance I do not consider that the
BNYMs appreciation of the risks associated with Sigma was such that it was in breach in
failing to speak to AP about its Sigma holding in January or February 2008, particularly
given the more positive note that appears to have existed at the end of the month.
March to April 2008
(i) The downgrade of Sigma
365. By early March 2008, the documents show that there was a move to a firm-wide solution
of the Sigma problem. I infer that it is from this time that securities lending and Standish
began to adopt a cooperative approach. There is a considerable amount of analysis within
the bank over this period, and it shows that monitoring of Sigma was vigorous.
366. The problem was pressing, because as S&P noted on 18 March 2008, Sigma had
approximately US$15bn in senior debt and repo maturities that would come due between
then and June 2008. (In fact in due course these liabilities were either met or rolled over.)
S&P moved Sigma from negative outlook to credit watch negative, implying that a
downgrade from AAA was now considered more likely.
367. Sigma itself was trying to persuade the bank to enter into a ratio trade. Mr Mannix reported
on 2 April 2008 that, Sigma called to tell us that essentially, things are getting worse for
them, not better, with the passage of time. They cannot access funding, and maturities
continue to drain liquidity. They suggested we strongly consider a debt for asset swap at
some multiple. Mr Mannix says that Ms Saisselin (BNYMs main point of contact with
the managers, Gordian Knot) had a tendency to overplay things if she thought this was
required in order to get things done. Whilst I agree that it was a considerable achievement
that Sigma managed to continue to meet its obligations at this time, I also consider that it is
very likely that things were indeed getting worse for it not better with the passage of time,
as Mr Mannix was told.
368. On 4 April 2008, Moodys downgraded Sigma from Aaa/P-1 to A2/P-2, and S&P
followed on 7 April 2008. BNYM minimises the importance of this, pointing out that this
still left Sigma with a mid-investment grade rating, and Moodys write-up pointed to
numerous positive features. It submits that both Moodys and S&Ps reports therefore
chimed with the Banks overall view that Sigma remained unlikely to default.
369. This is an unduly optimistic submission, in my opinion, particularly since the rating
agencies were perceived at the time to have seriously misread Sigmas true position. I
consider that losing its AAA rating was an important moment in the history of Sigma. An
article from the Financial Times of 10 April 2008 was circulated within BNYM. It said
that, Its management fought hard but it looks as though Gordian Knot's $40bn structured
investment fund, Sigma, faces a slow death". The reason given was that even if the market
revived, the loss of its AAA rating would prevent Sigma from funding itself at the prices
which would make the operation profitable. The significance of this is that a market
recovery would no longer provide Sigma with a return to normal business.
(ii) BNYMs views of Sigma at this time
370. BNYM submits that various presentations including those on 28 March 2008 and 7 April
2008 show that though the bank was considering capital support for various of its funds,
this was not linked to an expectation of a Sigma default, but rather the need to protect its
relationship with clients (and the resulting revenue stream) from the impact of Sigma being
downgraded and marked down in price. The documents in my view do not support this
interpretation.
371. The banks case is that it considered that the problem was one of liquidity, and that it
considered that Sigma would pay on maturity, and so believed that it was best to continue
to hold the securities. In closing, it submitted that there was wide room for different
views, and that it was at least a reasonable view. There is some support for this
submission in a briefing which Mr Tant and Ms Demmler gave to relationship managers
on 7 April 2008. A note records them as saying:
This is not an issue of quality, but rather of liquidity. SIGMA has high quality assets
and is favourably structured (e.g. no liquidity or NAV triggers forcing them into
wind down mode) vs. some of the other SIVs that have run into trouble during this
period. SIGMA has been very resourceful in managing through this period,
including having significantly shrunk the portfolio.
MV of portfolio of 95.59% with Senior Note coverage of 105.12% reflective of the
high quality/performing assets in the portfolio. As an example, the portfolio would
need to have a MV of below 90 before the capital [sic] note holders were negatively
impacted.
Actions they have taken while operating in a no growth mode since last summer
effectively have been to:
reduce the size of the fund from over $56b to just under $40b. Consequently,
leverage has been reduced from ~14% to less than 10% thereby enhancing the
position of the senior note holders.
outright sales of assets over $9 billion
repo $14 billion with 17 counterparties (duration of 7 mos)
ratio trade $4 billion with 4 counterparties
Because of the lack of liquidity in the marketplace, selling client/funds positions
would come at a significant cost vs. the underlying quality of the assets.
This briefing is consistent with the evidence of Mr Tant and Ms Demmler in these
proceedings.
372. However I am satisfied that this view did not prevail with more senior officers in the bank,
as is shown by the contemporary material. On 10 April 2008 Mr Ford circulated an email
to senior bank officials about a conference call that had taken place with the fund manager
Fidelity. He reported that Fidelity are more pessimistic than we are regarding Sigma's
life expectancy. They don't expect them to survive though 6/30/08. Based on the
results of this conversation, I intend to immediately return to our strategy of utilizing ratio
trades (at 3 to 1) with Sigma to the greatest extent possible to reduce our longer maturity
positions and increase the likelihood of the payment of our shorter maturities.
373. Shortly afterwards, BNYM conducted a ratio trade taking out a US$300m position in
Sigma securities for what I infer was a major Middle East client of securities lending. (In
accordance with the convention adopted by the parties, I shall avoid naming BNYM
clients.) What seems to have happened is that BNYM approached the client for
instructions first, but the client responded saying that it was for BNYM to take the
decision. BNYM says that it had to take action because the clients guidelines restricted
holdings to AAA securities. However, this is not the full story. An internal email from
the relationship manager refers to a significant concern that Sigma will fail in Q3 or Q4.
374. BNYM says the relationship managers concern arose because he had misunderstood the
situation. Its case is that it was the banks considered view, based on the analysis
performed by Mr Tant and Mr Demmler, that the most favourable outcome for clients was
to continue holding their Sigma MTNs. It cites a Credit Suisse report of 6 April 2008
which was relatively optimistic about Sigma held by money market funds.
375. Again, the ratio trade for the Middle East client was part of a picture. AP cites ratio trades
carried out for other clients in the sum of US$137m. BNYM says that between April and
June 2008, it concluded ratio trades on behalf of numerous commingled and segregated
account clients. In total, the bank conducted ratio trades for Sigma MTNs with a face value
of US$674.5m, which it says, at a 3 to 1 ratio, raised almost US$2bn in liquidity for
Sigma.
376. BNYM points to the raising of liquidity as a positive feature, but the fact is that for these
clients it was judged better to take on three times the par value of the Sigma securities in
other assets rather than continue to hold the securities themselves. BNYM says that this
course was not available to AP because of its guidelines and the nature of the assets on
offer which were predominantly longer than two years. But BNYM did not at this time
put to AP the option of loosening its guidelines, which could have been done, and I infer
happened in the case of other clients.
377. On 22 April 2008, Mr Ford and Ms Rulong made a joint presentation to the banks
Collective Investment Funds Committee with the title Securities Lending SIGMA
Investment Alternatives. Since these were the co-heads of securities lending at BNYM at
this time, what they said at the time is clearly significant as representing the view of the
bank. They pointed out some of the strengths of Sigma, as noted elsewhere in this
judgment.
378. However, they also explained the risks as they saw them at this time. These were that:
"Without additional funding, Sigma is likely to default before July, 2008 and a much
sooner default is possible. Default would expose BNYM and its clients to the
risks of the trustee liquidating Sigma's portfolio at a fraction of its realisable value if
held to maturity. Sigma currently holds assets which meet the investment
guidelines of our commingled accounts and many of our individual accounts. These
assets may disappear if other note holders exchange them for debt or lock them up in
repo agreements.
379. I consider that this is clear evidence of the gloomy nature of the banks analysis by late
April 2008. BNYM sought to explain the document in various ways none of which was
convincing. Although, as it points out, it is premised on the lack of additional funding, it
makes clear the problem that such funding gave rise to, namely the disappearance of
suitable assets if other note holders got to them first by way of ratio trades or locked them
up in repo agreements. (Ms Saisselin (of Gordian Knot) told Mr Mannix on 23 April
2008 that its funding needs to the end of September 2008 were US$18bn, averaging about
US$3.5bn per month, which gives some indication of the scale of the problem.)
380. Mr Fords suggestion in cross-examination that what was said about the risk of loss was
true but it did not include all the protective liquidation and bankruptcy payment
structures does not stand with the terms of the presentation (and is inconsistent with the
terms of an email sent by Mr Mannix the following day).
381. In particular, I reject Mr Fords suggestion that Ms Rulong was casting Sigma in the
most negative possible truthful light in order to get this committee to be as responsive as
we both thought they needed to be regarding the type of trading we needed approved.
Mr Ford avoided the language of misrepresentation, but that was the effect of what he was
suggesting. The idea that Ms Rulong would misrepresent the position to the banks
Collective Investment Funds Committee in order to get it to take action, or that Mr Ford
would allow her do so, does not bear scrutiny. (Ms Rulong did not give evidence because
she no longer works for the bank.) I am satisfied that the presentation stated their view as
heads of securities lending at the bank of Sigma at the time.
382. BNYM points out that the ratings agencies gave Sigma A ratings right up to the collapse
of Lehman Brothers, and says that ratings were historically good indicators of default
probabilities. It points to what Moodys was saying as late as July 2008 about the market
value of Sigmas portfolio, which it says supports the proposition that Sigmas failure was
the unpredictable result of the Lehman collapse.
383. However, I am satisfied that by early 2008, Sigmas rating was not regarded in the market
as a reliable indicator of the strength of the company. Further, as evidenced by comments
which are set out elsewhere in this judgment, it was not regarded as such by BNYM. By
now, that is, April 2008, it is clear that the bank placed little or no weight on Sigmas
rating (or the agencies analysis supporting their ratings) in assessing risk. In summary,
whilst the view that Sigma would pay in full at maturity may have been an available view,
it was not by this time the view which prevailed in BNYM. The next transaction
involving client I shows this.
(iii) The client I documents
384. This client was one of a number of significant US clients of the bank. At the end of April
2008, it was discovered that US$50 million of Sigma MTNs had been acquired for the
client in breach of its guidelines, and the question arose how the bank should handle this.
To some extent it is, in my view, a barometer of the banks beliefs as regards Sigma, since
any loss would be for its own account. The options were to hold the MTNs to maturity on
its own balance sheet, or do a ratio trade as principal, which would involve Sigma buying
them back at par, in return for the purchase by BNYM of US$150m of Sigma assets.
385. Commenting on the option of retaining the securities to maturity, Mr Ford said in his
witness statement that, Again, I did not think this risk [that is, the risk of Sigma
defaulting] would materialise, but it was a factor to take into account. Had I thought
default was likely, I would not have suggested it as a possibility at all.
386. This evidence that he did not think that default was likely was completely contradicted by
the banks late disclosure. As originally disclosed, the email chain does not include Mr
Fords email of 30 April 2008 at the head of the chain. Of the options, what he in fact
says in that email is that:
I think b is the best way to go as well. Sigma is likely to default by 9/15 September
2008 which would eventually lead to a realized loss and probably some disclosure
and reserves before that. We need to keep this moving or the proposed abs
securities may disappear.
387. This email is inconsistent with BNYMs case. In cross-examination Mr Ford asserted that
he exaggerated his concerns in order to get approval for the deal that he wanted done,
which was a ratio trade. I do not accept this. He forwarded his email to Ms Rulong and
copied it to Mr Palermo (who as I have said was a Vice-Chairman of the bank). As I said
in relation to the similar suggestion in relation to the presentation to the Collective
Investment Funds Committee, the idea that he would express a false opinion to get things
done does not bear scrutiny. I am satisfied that he said that Sigma was likely to default by
15 September 2008 eventually leading to a realised loss because that was what he thought
at the time.
388. In the event, his prediction as to the time of default was closehe was out by a week or so
and he was right in predicting that the default would lead to a realised loss. By now, it
was entirely predictable that Sigmas predicament would sooner or later have this result.
The risk was not in any way dependent on the unanticipated collapse of Lehman Brothers
as the bank has suggested. It is regrettable that this email was not disclosed.
389. In fact, BNYM decided not to retain the MTNs to maturity, but disposed of them by way
of ratio trade. The obvious conclusion, as AP says, is that this shows that a ratio trade was
seen as a better outcome than holding on to them.
APs retention claims: discussion and conclusion
390. AP submits that between March and 14 May 2008, BNYM senior management
embarked on a strategy of sales and ratio trades to reduce and eliminate Sigma exposure
for clients, including segregated and commingled clients, a strategy in which it says AP
should have been, but was not, included. Although as stated above there were sales, and
this is an important part of the evidence in the case, I do not think that the evidence
supports the submission that there was a generalised strategy of the kind alleged over the
March to May 2008 period. Nor do I think that AP has established that BNYM preferred
other clients over AP, since the sales that did happen were relatively limited compared to
BNYMs total Sigma holdings. By May 2008, when BNYM began contacting clients
about Sigma, AP was included. I do not accept, therefore, Mr Cirritos view that it was
treating AP as a third class client.
391. However, although I have rejected APs retention claim as regards the 2007 period with
little hesitation, it is plain that the argument that the securities should have been disposed
of, along with the alternative claim that it should have been contacted by BNYM about
Sigmas problems earlier, becomes much stronger with the passage of time.
392. BNYM objects that AP does not anywhere say what it believes the bank should have
assessed as the intrinsic value of the MTNs to serve as a comparator to their market price.
It says that it is impossible to see on what basis it can be considered unreasonable for the
bank to have reached a view that the most likely outcome was that the Sigma MTNs would
be repaid, in full, on maturity.
393. However, for reasons stated, I am satisfied that by April 2008, this was not the view
which prevailed in BNYM. By April 2008, it was recognised that Sigma was in a very
vulnerable position. As I shall explain shortly, what eventually prompted the bank to
contact its clients about the situation was the action by IDC, the pricing vendor, at the
beginning of May 2008, sharply reducing the indicative price of the securities. At that
point, I infer that the bank had little option but to explain the ramifications to its clients.
394. The issue is as to the extent of BNYMs obligations. The bank submits (with force in my
view) that the size of its Sigma exposure is directly relevant to the reasonableness of its
actions. There is obviously a difference between how a bank will manage an exposure of
US$35m and one of over US$5bn, particularly in the market conditions of August 2007
onwards. What might appear to be a reasonable course of action for one client in isolation,
as it says, may take on a very different complexion when considered in the context of
hundreds of clients.
395. The most significant point appears to me to be as follows. It is common ground that a sale
at this time could only have been accomplished at a substantial loss to AP. A ratio trade
would have got rid of the Sigma holding without an immediate loss, but it would have
involved AP substantially increasing its overall market exposure.
396. Further, BNYM says (and I do not think that this is in dispute) that a ratio trade could not
have been concluded within APs existing Investment Guidelines. Absent an express
instruction from AP therefore, the bank could not have been under any obligation to
execute such a trade, which would have amounted to a breach of contract.
397. More broadly, I am satisfied on the evidence that in practice transactions involving such
substantial implications for the client would not have been performed by BNYM without
consulting the client first and getting its instructions. If a recommendation was requested
by the client, it would doubtless be given. Mr Cirrito opined to the contrary, saying that,
It should just have been a case of BNYM calling AP to let AP know. I do not accept
that evidence. Whilst it is correct that the ratio trade for the Middle East client was done
without its express consent, this probably says more about the importance of the client,
than the extent of the banks duties as securities lending agent. Without such instructions,
I do not consider that BNYM as lending agent was legally required to exercise its
discretionary mandate and dispose of APs Sigma holding, whether under its duty of care,
or otherwise. While there may be exceptional cases, this would be a major requirement to
impose on a securities lending agent, and I do not consider that the evidence justifies it as
regards Sigma.
398. For that reason, I consider that the key issue is whether BNYM was under a duty to
contact AP about the Sigma situation, which is APs alternative case, and if necessary
obtain its instructions. As a matter of fact, up until the beginning of May, BNYM did not
contact its clients generally about Sigma, though it did thereafter. It would be a difficult
exercise, as it proved to be when it was done. It would also be a sensitive exercise,
because a wholesale disposal of the securities was not possible for reasons explained
above. It was ultimately a judgmental matter for the bank whether to contact clients, and if
so which, and at what point in time. Despite the force of APs contentions, on balance, I
do not consider that the position was such that BNYM was in breach of duty in failing to
communicate with AP about Sigma before it actually did so in May 2008.
399. If the above conclusion is wrong, I do not consider that any duty to dispose of the
securities and/or contact AP arose until April 2008, when Sigmas position was perceived
to have substantially deteriorated as described above. For these reasons, I find against AP
on its retention claim.
(3) APS CLAIM RELATING TO COMMUNICATIONS BY BNYM IN MAY 2008
The pricing of the Sigma MTNs
400. I have mentioned elsewhere that the prices given by BNYMs pricing vendor, IDC, were
much higher than were being realised in the relatively few actual sales of Sigma securities
of which there is evidence (the IDC prices were relatively close to par). It seems that on
about 22 April 2008 Standish sold US$50m December 2008 maturities at 68, which Mr
Fort described as a little desperate.
401. On 1 May 2008 IDC reduced its indicative prices on Sigma notes to 70 (for October 2008
maturities) and 68 (for March 2009 maturities). These were the maturities held by AP. I
am satisfied that this reduction represented a steep and sudden adjustment by IDC, and left
noteholders such as AP potentially facing a large loss.
402. For May/June 2008 maturities, which would fall due soon, Mr Robison felt that the IDC
price was too low. It is clear from the context that his concern was the effect that the IDC
prices would have on the NAV of the ICR fund. The bank substituted 97.20 for May
2008 and 95.8 for June 2008 (which were the remaining ICR maturities) on the basis of a
probability of repayment in full of 90% and 85% respectively and a recovery in the event
of default of 72%. (In fact, these notes were paid by Sigma at maturity.)
403. At this time, the bank produced calculations as to LGD (loss given default) in respect of
the various Sigma maturities in a spreadsheet Mr Tant sent to Mr Browne (Chief Risk
Officer) on 1 May 2008. Mr Tant said he could not recall who prepared it, but there is no
reason to suppose that he was not comfortable with the numbers. For the maturities from
September 2008 onwards, which included those held by AP, the analysis predicted a loss
of 28.5% based on a 75% chance of default and an estimated loss of capital of 38% in the
event of default resulting in projected NAVs of 71.5%. This is a very different calculation
from that applied to the May/June 2008 maturities.
404. BNYM says that it involved considering the lowest prices at which the Sigma MTNs
could be valued consistent with maintaining the commingled fund NAVs. It was, BNYM
says, a hypothetical downside scenario not intended to be a realistic estimate of the
expected loss. However, in the light of the other evidence I do not accept this, and agree
with AP that the document is self-explanatory. As AP says, it undermines BNYM's case
that it still believed that the AP Sigma MTNs were on track to being paid in full on
maturity, and is inconsistent with any belief by this time that there would no shortfall on
principal in the event of default.
405. The steep reduction in IDCs pricing of Sigmas securities had the consequence that in
May 2008 BNYM made contact with clients who were exposed to Sigma, or at least some
of them. In this case, attention has centred on two telephone calls between BNYM and
AP on 16 May and 19 May 2008. Before coming to them, I must deal with the evidence
as to the contact which was made with other clients.
The Standish letters
406. From early May 2008, Standish began to write to its own clients about Sigma. The letters
began by identifying the clients Sigma holding. The letters continued:
Based upon our continuing consideration of the recent market events and the
liquidity challenges and related financial difficulties Sigma is experiencing, and with
no certainty of relief being realized in the near term, we believe that there is a
significant likelihood that Sigma will not be able to continue to meet its commitments
in respect of the Sigma notes in the medium term. A default in its obligations under
the Sigma Notes will cause an enforcement event which will likely result in a
prolonged liquidation period as well as diminished principal repayment.
407. In an effort to mitigate this risk, the letters described an opportunity to conduct a ratio trade
with Sigma (at the usual 3 to 1 ratio for such transactions). It expressed the belief that the
substitute securities are of a better credit quality and prospects than the Sigma Notes and
will result in an over-all improvement of the portfolio. Because some of the substitute
securities did not conform to client investment guidelines, a waiver of those guidelines was
requested if the approach outlined was acceptable to the client.
408. In substance, the letters proposed that clients agree to a ratio trade to dispose of their Sigma
securities because of the significant likelihood that Sigma would default. The draft was
approved by outside lawyers, who made a number of amendments before it went out. I
reject BNYMs suggestion that this meant that its terms did not necessarily reflect the view
of the bank officers concerned.
409. BNYM says that these letters, which were disclosed late and are inconsistent with its case,
are irrelevant, because Standish (a BNYM asset management company) was a separate
corporate entity from the securities lending group of BNYM, and took its own credit and
investment decisions. Whilst this is correct so far as it goes, I repeat my finding that from
early March 2008 different parts of the bank began to adopt a cooperative approach as
regards Sigma. This is borne out by the similarity in letters sent by securities lending, even
if its officers were not aware of the Standish letters at the time they were sent. The
Standish letters are therefore relevant. (A suggestion in BNYMs written closings that
there was insufficient context to assess such letters by reason of limits on disclosure was
not correct, and not pursued in oral closings.)
Securities lending letters
410. Up to trial, there was one letter disclosed by BNYM sent by securities lending, which was
to a US client (client W) dated 29 May 2008 and signed by Mr Fort. With the necessary
adaptations to the securities lending context, the letter is the same as the Standish letters. It
contains the same reference to significant likelihood of Sigmas default, the likelihood of
a diminished principal repayment (i.e. a loss), and expresses the same belief that the
substitute securities are of a better credit quality and prospects than the Sigma notes.
411. Given BNYMs case, this letter plainly required some explanation. Mr Zimmerhansl said
in his report that, "With respect to the comments expressed by one individual from BNYM
to one client, this did not represent BNYM's official position and therefore was not a
conflicted view, rather it was a client accommodation effort and not a deviation from
BNYM's neutral approach". By conflicted view, Mr Zimmerhansl was referring to the
fact that the letter is inconsistent with the position taken by BNYM in this case.
412. Mr Zimmerhansl was unaware of the Standish letters when he made his report. However,
even leaving aside the Standish letters, further disclosure shows that the client W letter
was not the only one. The Oklahoma depositions refer to a letter dated 19 May 2008 to
another US client (client K) in the same terms. In his deposition, Mr Fort said that this
was a document that was provided for many clients in doing ratio trades on a separate
account basis, so this was more of a standard format than a letter that I handcrafted.
413. In cross-examination on this point, Mr Fort said that he thought that there may have been
one other, but that he did not recall how many letters there may have been. At any rate, it
is clear that Mr Zimmerhansls factual premise was incorrect in this respect.
414. BNYMs case on these letters is as follows. First, it submits that read closely, it can be
seen that the letters are merely putting a different spin on what is, at heart, the same
message, namely that the bank believed the most likely outcome to be repayment in full at
maturity, but that the risk of a worse outcome existed and could not be discounted. I reject
that. The banks case has been (to quote from its closing submissions) that it reasonably
concluded that Sigma was unlikely to default prior to March 2009. These letters express
the opposite conclusion.
415. BNYM submitted that not too much should be read into the word significant when
attached to the likelihood of default. In re-examination, Mr Fort, who was the signatory,
said that above 5 per cent would be significant (Mr Gordon agreed also in re-
examination). I reject that as an implausible interpretation of the term significant
likelihood of default. Clearly, a much greater probability of default is envisaged, and
hence the reason for the ratio trade.
416. In that regard, a proposed motion that was prepared for client Ws investment committee
recited that the client faces a substantial loss of principal, possibly up to 100% of the
Sigma notes. I accept BNYMs submission that the timing and content of the various
emails does not make good the contention that this information came from BNYM.
However, the proposed motion was emailed to Mr Fort in draft, and if he disagreed he
could have challenged it. He said in cross-examination that it was likely that he would
have telephoned to say that he disagreed with this language, but there is nothing in the
contemporary material to support this. I do not accept his evidence on this part of the case
unless supported by the contemporary material.
417. In fact, the evidence suggests that the terms of the letter were much clearer about the risks
associated with Sigma than the impression given by Mr Fort in phone conversations. In
an email of 20 May 2008 to Mr Fort, the client commented (in relation to a draft of the
letter):
"I had pretty much convinced myself that the wise move was to wait and see how
things progress over the next few weeks Then I read the letterand the way that
was worded made it seem much more likely that Sigma's position was in trouble
Are all the other note holders running for the exits with deals like this? I didn't think
things were that dire, but the letter indicates a "significant likelihood" of problems."
Mr Fort responded saying it is an evolving story so it changes from day to day.
This exchange is of some significance, because Mr Fort was a party to one of the phone
calls to AP at this time, and an issue between the parties is as to what was said to AP, and
what impression was given.
418. I further reject BNYMs suggestion that the ambit of significant likelihood of default
was restricted to medium term maturities later than APs maturities. This is contrary to
the terms of the letters which are in respect of Sigma Notes with stated maturities.
Insofar as Mr Zimmerhansl supports this suggestion, I do not accept his evidence in this
respect.
419. However, the primary explanation given by BNYM to explain the letter is as follows. It is
said that it was provided at the clients request to ease the passage of the ratio trade, and
that its contents did not in reality represent BNYMs view. To quote its closing
submissions, the client sought a document in writing that could be used to justify
expanding their investment guidelines so as to permit a trade that involved not merely
reducing their Sigma exposure, but at the same time taking on an increased exposure to a
variety of long-dated assets during a period of severe illiquidity in the credit markets.
Given that there was already a letter in existence that had been approved by external
counsel, and which conveyed the message sought by the client, it is hardly surprising that
this was the document that was used, nor that Mr Fort did not feel it appropriate to make
changes to the already approved language.
420. However carefully it is put, this explanation, as AP said, amounts to a suggestion that Mr
Fort (and by extension the bank) was involved in a deception of the client by sending a
letter which he knew to be false for the purpose of getting the clients investment
committee to approve a ratio trade. No bank would contemplate such a course, and I
regard the explanation as unsustainable.
421. In any case, this was not an isolated letter, because apart from the letter to another
securities lending client, Standish was writing to its clients in the same terms at the same
time. Further, the explanation does not find support in the other material. Neither the
clients email of 20 May 2008 that I have quoted above nor Mr Forts reply suggests that
the letter had been sought by the client to be used to justify expanding its investment
guidelines.
422. I agree with AP that the more plausible explanation is that Mr Fort believed in the matters
stated in the letters. That is my finding on this issue. I do not agree with BNYMs
suggestion that the letters are unrepresentative outliers. On the contrary, I consider that
they are consistent with most of the other contemporary documents at this time.
423. By this point in time, I am satisfied that Mr Tant agreed with this view. In cross-
examination he said that he largely agreed with the letter, but would have taken out the
word "significant". On that basis, the letter would have read, we believe that there is a
likelihood that Sigma will not be able to continue to meet its commitments in respect of the
Sigma notes in the medium term. As to the words diminished principal repayment, he
would have been happy with potentially diminished. This evidence is consistent with
the spreadsheet he circulated on 1 May 2008.
The background to the communications with AP
424. BNYM submits that it was its considered view, as communicated to other clients, that the
current market prices for Sigma MTNs did not reflect their intrinsic value but were a
reflection of market illiquidity, and that clients would be better served by holding them to
maturity than by selling the notes at such prices. The documents it relies on are as follows.
425. On 13-14 May 2008, a draft "representative letter" was circulated by BNYM to be sent to
clients participating in one of the Mellon cash collateral funds signed by Ms Rulong. It
was envisaged that there would be a different standard letter for each Mellon commingled
fund, and none for the ICR fund (which was a legacy BoNY fund), or for separate
accounts. The draft letter noted the recent drop in Sigmas IDC pricing, and stated:
"We believe that the application of such market prices to Sigma senior notes and the
resulting sharp decline in the Fund's NAV do not result in an actual impairment of
the Fund that will ultimately be realized. Rather we believe that the Fund will receive
higher values for its Sigma senior notes by utilizing a hold to maturity or other
tactical disposition strategy."
426. There is no evidence that this letter was sent, but it received attention in London, where the
AP client relationship function was based. (BNYMs credit analysis and market functions
were carried out in the US.) There was a suggestion that the draft letter should be attached
to monthly statements, presumably for clients generally, but on 15 May 2008, Mr Nigel
Taylorson who was Head of Relationship Management (Pensions) said that the letter only
applied to a particular fund, and that we will not send [the letter] since we will be
making calls instead. I will discuss individual client plans with you individually.
427. Later that day, Mr Taylorson emailed saying that I am not proposing to send letters and
instead call just [client X] and AP, but nobody else. In all these cases we will be reactive
only but we are ready to answer the questions if they arise (the chances are very strongly
that they will not!). Among the reasons he gave for not contacting other clients were that
their exposures were tiny, and that we believe that the situation is gradually improving
and if left to maturity in all likelihood no loss will be incurred, and that contact was more
likely to create the problem we are trying to avoid. (This seems to be a reference to clients
pulling out of the programmes.)
428. On 16 May 2008, a Q&A document was circulated dealing with particular Mellon funds
(AP of course had a segregated account), but BNYM says that it was to be used by
relationship managers on client calls about Sigma. The document says that BNYM does
not believe that the reduced prices would result in an actual impairment of the Fund that
will be ultimately realised:
Q. What is the outlook for SIGMA?
It is extremely hard to make concrete predictions. Analysis by Moodys, which
downgraded SIGMA by five notches from AAA to A2, shows the vehicle has sold
off $9.5bn of assets in the open markets to repay debt, while persuading some note
holders to take about $4.4bn of underlying assets in lieu of repayment.
At the same time, SIGMA has been working its banking contacts to arrange as
much funding as possible in the form of repurchase, or repo, agreements, raising
about $14bn from 17 different lenders.
Q. What is the outlook for the Funds?
We do not believe that the application of the above mentioned market prices to the
SIGMA senior notes, and the resulting sharp decline of the Funds shadow NAV,
will result in an actual impairment of the Fund that will be ultimately realised.
In fact, we believe that the Fund will receive higher values for its SIGMA senior
notes by utilizing a hold to maturity or other tactical disposition strategy.
This is consistent with the cash collateral reinvestment strategy BNY Mellon Asset
Servicing has followed on your behalf to navigate through these difficult market
conditions.
Accordingly, BNY Mellon Asset Servicing continues to be able to operate the
Funds for all daily loan and maintenance activity on an amortized cost, $1/! NAV
per unit basis.
429. In the light of the other BNYM material from this time set out above, I do not accept its
submission that the draft client letter and the Q&A reflected the considered view of the
bank as to the risks attendant on holding the Sigma MTNs at this time. At best, they gave
a partial view. However, the documents were tailored to commingled funds, and for
clients in funds (unlike Sigma) the important point was probably the last one made in the
Q & A, that BNYM would continue to operate the funds for all daily loan and
maintenance activity on a $1/! NAV per unit basis.
430. In any case, neither document was sent to AP. Though AP was to be called by phone, no
letter was sent to it. Clearly, a letter could not have been sent that reflected the statement in
Mr Taylorsons email that we believe that the situation is gradually improving and if left
to maturity in all likelihood no loss will be incurred. This would have stated the opposite
conclusion to the letters that securities lending were sending to other clients at the same
time.
The call of 16 May 2008
431. The call to AP was made on Friday, 16 May 2008 to Ms Hammarlund by Mr Gordon and
Ms Jobling, the Client Service Officer who dealt with AP in relation to securities lending
(she is no longer employed by BNYM and did not give evidence). No advance notice of
the call was given, as might have been expected, and Ms Hammarlund described it as
coming out of the blue. It was a short conversation lasting about five to ten minutes.
432. It was the first time that Ms Hammarlund had been contacted about Sigma (or any
security) before. On the BNYM side, Ms Jobling seems to have known something about
the Sigma issue, but Mr Gordon only knew what he had learned the day before. I doubt
either was in a position to give any real analysis of the position. They clearly knew
nothing of the background as set out above.
433. There is no dispute of substance as to what was said. Mr Gordon says in his witness
statement that, We informed Ms Hammarlund about the recent repricing and expressed
the view that although the Sigma MTNs had been marked down there was no cause for
panic as the Bank believed that the Sigma tranches would be paid in full at maturity. Ms
Hammarlund appeared calm and said that she would pass the information on to Ms
Thomasson-Blomquist. Though she was calm, Mr Gordon said that Ms Hammarlund
understood the seriousness of the pricing reduction.
434. Ms Hammarlund made a note of the call because she needed to keep Ms Thomasson-
Blomquist (who had responsibility for the financial performance of APs securities
lending programme) informed. The note (in English translation) records that she had had a
discussion with BNYM about the balance in APs cash reinvestment portfolio. In relation
to Sigma there is a balance that they are intending to keep till maturity which equals
about 2% of the cash reinvestment program.
435. She reported that, They had a maturity recently which was processed without any
problems. Sigma pays all its interest due without any problems and has got good
reputation. At the same time the pricing in that case for the cash reinvestment portfolio
was based on the rate of 80, since another player left the position prior to maturity. Mellon
says they are completely confident that Sigma is going to fulfill its obligations, but cannot
obviously guarantee anything. They want to inform their customers, but believe that one
should sit still for a while. They monitor it daily.
436. Except for the part that records that BNYM was completely confident that Sigma was
going to fulfil its obligations, it broadly accepts this note. Perhaps those precise words
were not used, but I am satisfied that the message was a reassuring one. This follows
from his witness statement, in which Mr Gordon says that the banks view was that if
held to maturity the Sigma MTNs would pay with no loss to our clients. He accepted in
cross-examination, obviously rightly, that he would not have been speaking to Ms
Hammarlund in the terms he did if he had been aware of the letters that BNYM was
sending to other clients at the time.
437. I do not accept the banks submission that the purpose of the call was simply to alert AP to
the situation and ask if it wanted a fuller discussion. Mr Gordon did not regard this as a
preliminary call, to be followed by a more detailed briefing. He says that the request for a
further call came from AP. This was prompted by Ms Hammarlunds note to Ms
Thomasson-Blomquist saying that, If you need more information, I can arrange a
teleconference with Steve and Verity on Monday. Verity can also send more information
about Sigma. A further conference call was requested by Mr Grunditz and was fixed for
Monday, 19 May 2008.
The call of 19 May 2008
438. Mr Gordon said in cross-examination that a more balanced picture was given on 19 May
2008, and this is the banks case. The call took place at 10.30 am, and AP was
represented by Ms Thomasson-Blomquist and Mr Grunditz (Ms Hammarlund could not
attend), and BNYM was represented by Mr Gordon, Mr Tant and Mr Fort, (Mr Skeel
stood in for Ms Jobling). The only record is in the form of notes jotted on an email by Mr
Gordon. That email was from Mr Skeel to Mr Fort and Mr Gordon setting up the call,
and said that it is just to provide a little more information and speak to additional people at
the client who were not present on Friday.
439. Mr Grunditz's evidence was that, To the best of my recollection we were informed by
BNY Mellon that although the price of the Sigma notes was 80% during a recently
performed transaction, Sigma was a company which had recently met its payment
obligations and BNY Mellon were confident that Sigma would be able to meet its future
obligations. BNY Mellons view was that we should not rock the boat and that we should
continue to hold the notes which were set to mature in October 2008 and March 2009.
BNYM points out that this is similar to Ms Hammarlunds note of the earlier call. He
accepted that he could not remember verbatim what had been said.
440. Ms Thomasson-Blomquists evidence is that the purpose of the call was for BNYM to
provide additional information, and that BNYM informed AP that it was not their intention
to sell the Sigma MTNs. She said that, Based on the information they gave us both in
Verity Joblings call to Gun Hammarlund and during our telephone call, I did not think
there was any reason to question their decision to hold onto the Sigma notes.
441. She said in cross-examination that they were told that they had no reason to worry about
Sigma. She did not accept that they were told that, No SIV can really exist going
forward, which is a statement in Mr Gordons note. Since the note is the only
contemporary record, I accept that this was said. However, it is of limited relevance, since
the issue was not whether SIVs could go forward (the market understood that they could
not), but whether Sigma would nevertheless pay on maturity. Ms Thomasson-Blomquist
said that the purpose of the call was not, as she understood it, that BNYM wanted further
instructions or a decision from AP. I accept that evidence, and find that AP was not asked
to and did not take a decision. She did however agree in cross-examination that there came
a point in the conversation when the bank, having explained its position, asked if AP was
happy to go along with it, and AP said something like, We agree with you and there is no
need to sell or to exit immediately.
442. On BNYMs side, Mr Fort said in his witness statement that he does not remember the
call. In his oral evidence, he said:
A. I think what I have testified and what I believe to have said to clients at that
time was that it was our belief that the assets -- that the securities would pay out
on maturity but that it was not a guarantee. The reason we were having these
discussions with clients is that there is -- there are issues surrounding Sigma and
there is an outside chance that a default could occur.
However, if that is so, he was telling different clients different things at the same time. An
outside chance that a default could occur is clearly different from the significant
likelihood of default in the letters he sent. It is for this reason, that I cannot accept his
evidence on this part of the case.
443. Mr Tant said that he did not recall the call in detail, but that it did not focus solely on
Sigma, but also addressed how the portfolio might be managed in the prevailing market
environment. He recalls that AP was informed that Sigma was facing challenges, but that
BNYM retained confidence in it because it had been successful in finding other sources of
liquidity and doing the right things against a difficult market backdrop, such as boosting
liquidity and de-leveraging.
444. He says that, I also believe that during the call, the possibility of a ratio trade was
mentioned. While I cannot recall this specifically in relation to the AP call, I recall that
generally on client calls regarding Sigma, Bob Fort would explain that there was an
opportunity for a client to enter into a ratio trade. The possibility of a ratio trade is not
mentioned in Mr Gordons note and is not supported by the other witnesses, and my
finding is that the subject of ratio trades was not mentioned in these phone conversations.
445. The most significant participant on BNYMs side was Mr Gordon, who was Relationship
Manager for AP, and the only person to be on both calls. In his witness statement, he
refers to his note, and says that, we repeated that there was no need to panic. Mr Tant
and Mr Fort explained that the price reduction was the result of the sale of a Sigma note by
a hedge fund that had led IDC to drop all of its prices, however they remained confident
that Sigma would continue to perform and pay out at maturity on the October 2008 and
March 2009 notes held by AP. They explained that Sigmas underlying assets remained
of high quality and that a recent maturity had been paid out in full. AP agreed that there
was no need immediately to exit Sigma but asked if we could think of ways to reduce its
risk without sacrificing revenue.
446. Leaving aside the unexplained reference to sale by a hedge fund, BNYM says, I consider
rightly, that Mr Gordon had a much clearer recollection than Mr Tant or Mr Fort.
However, I do not think (as it submits) that the telephone call involved an in-depth
discussion of Sigma. Nothing in the evidence supports this, and I consider that it is more
likely that the discussion was superficial.
447. As I have stated, Mr Gordons witness statement says that Mr Tant and Mr Fort told AP
that they remained confident that Sigma would continue to perform and pay out at
maturity on the October 2008 and March 2009 notes held by AP. When the
contemporary bank documents with a different message were put to him in cross-
examination, he qualified this saying that AP was told that, This asset type is finished, but
for 5 months, for 10 months, were hoping it's going to be okay for you. In re-
examination, he agreed with the passage from Mr Forts evidence that significant
likelihood of default meant a 5 per cent chance (an interpretation that I have rejected).
448. I accept that the bank did not give the impression that there was a guarantee. Otherwise, I
found this further evidence of Mr Gordon unconvincing, and do not accept it. I find that
his witness statement gives an accurate summary of the call, and that AP was told, not that
BNYM was hoping it was going to be okay, but that it remained confident that Sigma
would pay out at maturity on the notes that AP held.
Events following the phone calls
449. Based on another note that he found, Mr Gordon thinks that there was another call
between himself and Ms Hammarlund on 20 May 2008. This was only produced after
APs witnesses had given their evidence, but in any case I do not think that it takes matters
much further. The note records the fact that at current prices, AP faced a US$10.5 million
loss on the Sigma MTNs, which is not in dispute.
450. In an internal email of 21 May 2008, Ms Jobling said that she had found out that AP was
a bit scared by the Sigma holding. She had to go back to AP with some additional
information about reducing risk, but theyre not looking to force a sale of any assets that
are under water but now they are aware of the situation they are looking to react quickly.
451. On 23 May 2008, Ms Jobling sent a lengthy email to Ms Hammarlund and Ms
Thomasson-Blomquist dealing with the management of risks, as they had asked, and
making various suggestions. The email goes on to deal with Sigma, which it describes as
an impaired asset. In the course of the email, it raises the possibility of an asset
swap:
We have undertaken a review of your cash collateral investment pool and I can
advise that were currently running very high liquidity within the fund (around
32%). We believe this to be a strong portfolio, with SIGMA being the only
impaired asset. We have reason to believe that we will see improvements of this
asset at May month end, however this does depend on any trading activity that
may take place in the market of this security between now and then.
As you know, our strategy is a buy and hold one. Were intending to hold these
positions until maturity. SIGMA is still making timely interest payments, and
there was a full maturity on the 14th May 2008 of one line which we hold within
our other funds. One option available to us would be to do an asset swap for a
portion of the SIGMA position within your portfolio. This is something wed
need to look into further if you were considering this option. The main issue with
this is that the assets we would receive would have a longer duration than those
currently permitted within your reinvestment guidelines. We would only be able
to do this for those assets that we are comfortable with and of issuers that we
have previously completed our due diligence on. Can you let me know if this is
something youd like us to take further for you?

I hope that I have given you some food for thought. Depending on which route(s)
you wish to go down, we will have to undertake some additional analysis. Please
feel free to contact me if you have any questions on any of the above points and I
hope to hear from you soon.
452. BNYM submits that it thereby suggested an asset swap (i.e. ratio trade) to reduce APs
Sigma exposure. This would require AP to take assets outside its guidelines, and it asked
AP for guidance as to what it wanted the bank to do and whether it required any more
information. However, it says, AP fell into a torpor. It never responded to Ms Joblings
request that it contact her if it wanted more information about a possible asset swap. The
reason is (it submits) that AP had no interest in concluding such a trade. Nor did it ask
BNYM for a recommendation. It did not regard selling the Sigma MTNs as an attractive
option, because this would involve crystallising a loss. AP appreciated full well that there
was a risk that the prices of the Sigma MTNs would fall further and that the only way to
avoid any exposure to further price falls was to sell them. In choosing to keep them,
BNYM submits that AP accepted the risk of any further falls in their value, including to
the point of default.
453. APs evidence was as follows. In cross-examination, Mr Grunditz said that for AP to
have taken action there would have had to have been a clear analysis as to why BNYM
made the proposal, so as to give it something to base its decision on. A sentence in an
email about a swap, he said, was not enough. He said that rather than explore an asset
swap, AP decided to tighten its investment guidelines. When it was put to him that ratio
trades had a disadvantage in that AP would in effect be buying parts of Sigma's portfolio at
the par value when in fact they were not trading at par, he said if there would have
been a better result in the long run or overall to do that, and if we had good documentation
to support it, we could have done so. Everything is based upon the fact that you have
good documentation with a good analysis and a proper recommendation from Mellon that
we can actually go with. He said that if BNYM had given a recommendation to sell, AP
would have considered doing so.
454. In cross-examination, Mr Rahmn said that, If a situation arises whereby we are expected
to take a decision or where the bank considers that we should take a decision, then, of
course, there had to be adequate information with analysis and proposals for what it is
we have to take a decision on, and that's happened in the past where there has been a
situation whereby [BNYM] has requested that AP takes a decision and they have also
presented us with various proposals to decisions with the recommendations and also with
supporting explanations as to why.
455. Similarly, Ms Thomasson-Blomquist denied the suggestion that AP had a general
approach of seeking to avoid crystallising losses. Her evidence was that in view the
information we had been given concerning Sigma, there seemed no need to swap all or
part of APs position in Sigma (whose price BNY Mellon expected to recover) for assets
of an unknown quality and which would require us to relax our investment guidelines.
APs witnesses were generally reliable, their evidence on this point is credible, is not
contradicted in the contemporary material, and I accept it.
APs communications claim: discussion and conclusions
Findings on this issue
456. I have set out above my finding that a securities lending agent is expected to communicate
with its client if there is a serious risk of loss in respect of securities held as collateral for
the clients account. I consider that such a duty arose in this case in May 2008 after the
reduction in the pricing of the securities by IDC. However, this is academic, because
BNYM did in fact contact AP about Sigma at this time. Having done so, BNYM accepts
that it was under a duty to do so fairly. This was a correct and inevitable concession.
457. The parties respective cases in summary are as follows. BNYM submits that AP was
given a balanced picture of Sigma. AP submits that representations were made to AP in
the phone calls that were false or misleading, and that BNYM did not take reasonable care
in its communications.
458. I begin by noting that client calls following the IDC price drop must have been difficult,
and I infer that the securities lending officers had little or no experience of this kind of
exercise. As explained earlier, collateral in this business was (in Ms Demmlers words)
expected to be money good. Something of the flavour is caught in Mr Fords email to
Mr Palermo of 31 January 2008, in which he says that the treatment of clients in the
situations that may possibly present themselves will be in fairly uncharted territory. That
was a fair comment, in my view.
459. BNYM submits that the bank was not, as it put it, dealing with ingnues. It is correct, and
pointed out elsewhere in this judgment, that AP was an investment professional. Ms
Thomasson-Blomquist accepted that she knew that SIVs had problems in the market.
However, AP clearly could not be expected to have performed the kind of scrutiny of
Sigma that had been undertaken by BNYM over the previous months. There was no
specific alarm bell ringing until the beginning of May, since Sigma prices were reported by
BNYM as close to par. In the circumstances, it was reasonable, in my opinion (as its
witnesses said) for AP not to question BNYMs expertise.
460. I am satisfied that the view conveyed to AP in the May communications was that BNYM
was confident of repayment, and that the notes should be retained. Although BNYM may
not have been under any obligation to give a recommendation (because it was not acting in
an advisory role), it did in substance do so. AP would probably have asked if it had not.
461. What was said has to be placed against the other evidence. I have set this out in detail
above, and need not repeat it. It is sufficient to compare the position of client K which
like AP had Sigma holdings maturing on 30 October 2008 and 12 March 2009. The letter
to client K is dated 19 May 2008 (the copy in evidence is not signed), that is the same
day as the second call to AP. As explained above, the letter says that BNYM believed that
there was a significant likelihood of a default by Sigma which would likely result in a
prolonged liquidation period as well as diminished principal repayment. This client was
told that it was better to have substitute securities than the Sigma notes, and encouraged to
waive its investment guidelines so that a ratio trade could be performed. Such a trade
would have the disadvantage, as BNYM points out, of the client taking on an increased
exposure to a variety of longer-dated assets. But that was deemed preferable to continuing
to hold Sigma.
462. These client communications were not, as BNYM submitted, different versions of the
same theme, but are opposite, and irreconcilable. The difference in the impression made
on the clients is (in my view) shown by the email of 20 May 2008 from client W to Mr
Fort (see above). It is clear from that email that after talking to Mr Fort, the clients
impression was that the wise move was to wait and see how things progress. This was
similar to the impression that was given to AP. But then the client read the letter, and the
way that was worded made it seem much more likely that Sigma's position was in trouble
I didnt think things were that dire.
463. The banks view of Sigma can be seen demonstrated in the ratio trades it was carrying out,
in particular, by reference to client I. As noted above, because of the breach of that
clients guidelines, any loss arising on the Sigma holding would be for the banks account.
It decided not to retain the MTNs to maturity, but disposed of them by way of ratio trade.
This reflected its belief at that time that Sigma was likely to default by September 2008
eventually leading to a realised loss. So far as the evidence in this case is concerned, that
was essentially the view expressed in the client letters, which, whatever differences of
opinion there may have been internally, and whatever was being said on the phone at the
time, must in my opinion be taken to state the banks position.
464. In communicating with AP about the Sigma notes, the bank had to give a fair view of the
risk of default and loss, and what the alternatives were to holding the securities to maturity.
On the facts, I conclude that BNYMs communications with AP about Sigma at this time
did not give a fair view. I make it clear that I am satisfied that there was no deliberate
attempt to mislead (and reject any case based on falsity), but that was the unintended effect.
By telling AP that it remained confident that Sigma would pay in full, when its analysis at
that time was that there was a significant likelihood of default, BNYM seriously played
down the risks. A balanced picture would have made it clear that there was real concern
within BNYM about the creditworthiness of Sigma and the possibility of default and loss
of capital to MTN holders such as AP in a liquidation.
465. Further, AP was not told in the phone calls that there was an alternative to either a sale, or
holding to maturity, in the form of a ratio trade. There was a reference to the possibility of
an asset swap in the email of 23 May 2008. However this has to be seen in the light of
what AP had been told about the likelihood of default. The fact that APs guidelines
precluded such a trade, as BNYM has emphasised, is not an answer, because other clients
were being invited to relax their guidelines, and AP could have done so too, had the matter
been put to it properly. I should add that the case of both parties in oral closing
submissions was that at this time there were assets of sufficient quality left in Sigmas
portfolio to make a ratio trade possible. (It appears that no ratio trades were carried out
between BNYM and Sigma after June 2008 because Sigma no longer had assets of
sufficient quality available to meet the requirements of securities lending clients.)
466. There was nothing in the email of 23 May 2008 to modify what AP had been told on 19
May 2008 in the phone call. BNYM confirmed that its strategy in relation to Sigma was a
buy and hold one, and that it intended to hold the positions until maturity. The reference to
an asset swap had none of the detail contained in the letters to other clients as described
above. In those circumstances, I am satisfied that AP cannot be criticised for not pursuing
the matter. Given what it had been told about BNYMs view as to repayment of the notes,
it is also not surprising that AP did not instruct BNYM to sell them, thereby incurring a
large loss. For the same reasons, nothing in my view turns on the fact that on 17 June
2008 AP did in fact instruct BNYM to tighten its guidelines.
The legal analysis
467. That being the factual position, I turn to the legal analysis. APs case is that BNYM made
representations to AP to the effect that (a) there was no need to be concerned about the
Sigma MTNs but that the fall in their price was attributable to lack of liquidity in the
market rather than problems with Sigma or the MTNs themselves, and that (b) though
there were no guarantees, there was no reason to believe that the Sigma MTNs would not
pay out in full at maturity. AP submits that BNYM (1) did not take reasonable care in
making the representations and/or did not have reasonable grounds for making them, (2)
alternatively, what was said was misleading in that relevant facts were omitted in
circumstances where BNYM had a duty of full disclosure of material facts to AP by
reason of its agency and/or fiduciary relationship, (3) the representations constituted
negligent misrepresentations and/or misleading partial representations, and (4) BNYM did
not make full disclosure in relation to the option of a ratio trade in its email of 23 May
2008.
468. In written closings, BNYM submitted that (1) the views expressed by the bank in the
telephone calls of 16 and 19 May 2008 regarding the prospects for the Sigma MTNs were
non-actionable statements of opinions that, in any case, were reasonable and reflected the
banks considered view of Sigma at the time, (2) it was not negligent of the bank to
provide such views to AP, nor was the bank under any obligation to provide additional
information regarding the range of internal (or market) views about Sigma, (3) BNYM
owed AP no fiduciary duty to give full disclosure of information regarding Sigma, nor
of the steps it had previously considered in relation to the ICR fund, nor, in the absence of
a request from AP, did BNYM owe AP any duty to provide AP with additional
information or a recommendation regarding the ratio trade suggested in the email of 23
May 2008, and (4) As a result of these communications, from 16 May 2008 (or, at the
latest, 19 May 2008), AP was aware of, and accepted, the risk of further declines in value
of the Sigma MTNs.
469. Mr Hapgood QC rightly accepted that if I found that the banks presentation of the Sigma
risk to AP was not a fair one, it would incur liability to AP, and that no points arose on the
pleadings. In the light of that concession, discussion as to the legal analysis in closing was
relatively limited. That is my finding, and except for its submission that it did not owe
fiduciary duties to AP, which I accept, I reject its points set out above. I reject the
suggestion that the statements made were non-actionable statements of opinion, since
BNYM factually misstated what its view of Sigma was, and I find that it was negligent of
the bank to tell AP that it remained confident that Sigma would continue to perform and
pay out at maturity on the October 2008 and March 2009 notes. While I agree that
BNYM owed AP no fiduciary duty to give full disclosure of information regarding
Sigma, it accepts that it had to give sufficient information to put the position fairly, and I
am satisfied that it did not do so. Whilst it is correct that AP continued to hold the
securities, it did so on the basis of the defective communications made by BNYM. For
negligent misstatement purposes, it was not in dispute that this was a relationship of
proximity within the Hedley Byrne line of case law.
470. It follows that I accept APs submission that in communicating with it in May 2008,
BNYM did not take reasonable care in making the representations it did about the Sigma
MTNs, and that what was said was misleading in that relevant facts were omitted which
were necessary to give a proper picture. I accept its submission that the representations
made constituted negligent misrepresentations and/or misleading partial representations. I
consider that BNYM did not adequately put to AP the option of a ratio trade in its email of
23 May 2008. I accept APs case on negligent misstatement/negligent misrepresentation.
471. However, I consider that the preferable analysis is based on breach of duty. As stated
above, by clause 10(b)(i) of the Securities Lending Authorisation Agreement, the bank as
lending agent had to perform its obligations under the agreement with the care, skill,
prudence and diligence which a prudent securities lending agent would use. In my
opinion, where a securities lending agent contacts its client about risks concerning a
security held for the clients account, it must present the risks in a fair manner, both under
its contractual duty of care, and under the equivalent duty of care that arises in tort. In the
case of the Sigma notes, the bank had to give a fair view of the risk of default and loss, and
what the alternatives were to holding the securities to maturity. Effectively, the banks
witnesses accepted that this duty arose as a matter of good practice, and I consider that it
arises equally as a matter of law. In performing this task in May 2008, BNYM fell well
short of the standards which it rightly set itself. I consider that AP has made good its case
in this respect.
CAUSATION, REMOTENESS, AND CONTRIBUTORY FAULT
472. The parties submissions on these three topics were understandably brief. As to causation,
BNYM contended that there are two aspects to consider. There is factual causation, that is,
whether as a matter of fact BNYMs breach caused the loss for which AP claims. Then
there is what it calls hypothetical causation, which is whether, if the bank had sought
instructions from AP whether to sell the Sigma notes or enter into a ratio trade, AP would
have given such instructions.
473. The point which BNYM makes on factual causation is that from either 19 May 2008,
alternatively from 17 June 2008 when AP instructed BNYM to tighten its guidelines, AP
knowingly accepted the risk that an asset which it knew to be impaired issued by an
entity which it knew to be in wind-down would fall further in value. It accepts that if I
find that it misrepresented the position to AP or put it in a way that fell short of its duty of
care, the point does not arise, since the acceptance of risk would have been induced by
BNYMs fault. I have made that finding, and so need say no more on this point.
474. The point which BNYM makes on hypothetical causation is on the basis that in the run
up to trial Mr Grunditz and Ms Thomasson-Blomquist put in supplemental witness
statements to the effect that if BNYM had expressed views in the same terms as Mr Servis
and Mr Cirrito, AP would have instructed BNYM to exit APs Sigma position. BNYM
describes this evidence as opportunistic.
475. However their evidence was not posited only on APs expert evidence, but also on the
facts as then known by the witnesses. The disclosure given by the bank of the Oklahoma
depositions and the further documents referred to earlier in this judgment strengthened
APs case as to what BNYM thought about the Sigma risks at this time. This is basically
a factual matter. I do not accept, therefore, that APs case on hypothetical causation
cannot succeed unless the court prefers the evidence of APs experts to that of BNYMs
experts (this suggestion was not pursued in oral closing).
476. I have referred to the evidence of APs witnesses above. In his evidence Mr Magnusson,
who became Managing Director of AP in March 2008, said that in view of the serious
situation affecting Sigma, and had BNYM given it full information, he would have been
concerned to protect APs assets and he believes his decision would have been to exit the
Sigma exposure as quickly as possible and in the way that best protected AP's interests.
He was a good witness, and I accept his evidence, as well that of APs other witnesses in
this respect.
477. I accept APs submission that had AP received a letter in similar terms to that addressed to
client K on 19 May 2008 or client W on 29 May 2008, AP would have exited its
Sigma exposure, whether by ratio trade or by sale at the price available, realising proceeds
of the order of US$25-26m for its Sigma MTNs. I am satisfied that it has proved its case
on causation.
478. As to foreseeability, BNYMs contention is that the actual risk that materialised was not
within the contemplation of the parties. It submits that the losses claimed by AP result
from a combination of exceptional circumstances: the sudden loss of liquidity in credit
markets from August 2007, and the financial tsunami that resulted from the failure of
Lehman Brothers thirteen months later. Both were unprecedented, and neither can be said
to have been likely or within the reasonable contemplation of the parties at the time the
GCA and SLAA were agreed in 2004.
479. I doubt that the assertion that the financial tsunami resulted from the failure of Lehman
Brothers is correct. This was part of the crisis that came to a head in September and
October 2008. As Rix LJ said in Rubenstein v HSBC Bank plc [2012] EWCA Civ 1184
at [118], although the Lehman Brothers collapse was both a symptom and a
contributory cause of market turmoil, the underlying causes of that turmoil went infinitely
beyond Lehman Brothers' difficulties. It stretched to a failure of confidence in marketable
securities in which there had previously been greater confidence. And what is new about
that? As he said about the issue as it arose in that case, The insolvency of Lehman
Brothers may have been unforeseeable, but Mr Rubenstein was not invested in Lehman
Brothers (also at [118]).
480. The facts are different, but it seems to me that this approach is applicable here too. It was
within the reasonable contemplation of the parties (see The Achilleas [2008] UKHL 48)
that an issuer of securities in which cash collateral had been invested would get into
difficulties, even if the credit crunch and subsequent financial crisis had never happened. It
was also within the reasonable contemplation of the parties that if BNYM failed to present
the position about an issuer in difficulties fairly to a noteholder like AP, when it had a duty
to do so, a loss would be incurred which was otherwise avoidable. The issue does not
depend on the foreseeability or otherwise of Lehmans collapse, and I consider that AP
was justified in not cross-examining Professor Hubbard on that subject.
481. BNYM has sought to draw a distinction between foreseeability of default, which I think it
accepts, and foreseeability of resultant loss. The suggestion is that the bank believed that
even on a default, Sigmas assets (taking into account the capital cushion) would be
sufficient to meet the claims of senior noteholders like AP in full. This point fails on the
facts. As I have said elsewhere in this judgment, the failure of Sigma and resultant loss to
holders of its debt was entirely foreseeable. The evidence is that it was foreseen by
February 2008, and the position thereafter deteriorated. There is ample evidence that
BNYM was well aware that loss to noteholders could and probably would result.
482. In short, the failure of Sigma with resultant loss to holders of its securities was not only
foreseeable, but was foreseen by BNYM. As AP said in its closings, there is copious
evidence to the effect that senior management of BNYM were very concerned indeed
about the significant likelihood of default of Sigma and the serious risk of loss of capital to
Sigma MTN noteholders, particularly those holding post September 2008 maturities like
AP. They were right to be, as its assets disappeared in repo loans, and ratio trades. For
these reasons, I reject BNYMs case on foreseeability.
483. As to contributory fault, the main criticisms made by BNYM were that AP (1) failed to
monitor its portfolio, a criticism aimed in particular at Mr Grunditz, (2) failed to include
SIVs in the list of prohibited investments at the end of clause 2 of the Investment
Guidelines, (3) failed to appreciate the potential impact of the credit crunch on its
portfolio, (4) failed following its communications with BNYM in May 2008 to take any
steps independently to investigate the creditworthiness of the AP Sigma MTNs (BNYM
says that it could have asked BlackRock as a specialist external manager for US corporate
bonds for advice), (5) rejected a ratio trade without seeking further information from
BNYM about such a trade, and (6) instructed BNYM in June 2008 not to sell any assets
at a loss, despite being aware of the increased credit risk being run by the AP Sigma
MTNs.
484. As to (2), this could only apply to APs acquisition claim, which I have rejected. As to the
others, AP has succeeded on the third claim (communications made to it in May 2008),
because of the deficiencies in the way that BNYM put the risks inherent in the Sigma
holding when it contacted AP in May 2008. I am satisfied that AP cannot be criticised on
any of the grounds asserted by BNYM, given the way the position was presented to it.
Mr Zimmerhansls evidence on this point does not give sufficient weight to this. I refer to
the discussion above in this respect which I shall not repeat. I only add that the criticisms I
have made as to APs monitoring of the securities lending operation do not apply in this
context, and nothing was said by BNYM in the May communications that indicated the
need for a second opinion on the Sigma MTNs from BlackRock. In those circumstances,
I accept APs submission that its loss was not caused by or contributed to by any of the
factors identified in BNYM's submissions.
QUANTUM
485. The parties are agreed that if I find in favour of AP on liability, as I have on its third
ground, they will be able to agree quantum. If for any reason that should not be possible, I
will give a further ruling.
OVERALL CONCLUSION
486. I find against AP on its claims relating to the acquisition and retention of the Sigma MTNs,
but find in its favour on its claim in relation to how the position was explained to it in May
2008. The overall result is that AP is entitled to judgment. I am grateful to the parties for
their assistance, and will hear them as to any consequential matters.