The Judgment in this case, handed down on 9 March, has provided a rare opportunity for the court to examine misselling claims in the context of complex financial products where the parties to the action are both banks. The Judgment is lengthy and what follows is a brief summary of the facts and the findings of the Court.

The facts

The dispute concerned the sale to the Claimant ("CRSM"), a San Marino bank, by the Defendant ("Barclays") of a series of four sets of structured notes with a total nominal value of €406m and the subsequent restructuring of the notes. CRSM claimed that it was induced by misrepresentations from Barclays both to buy the notes and to agree to the subsequent restructuring of the notes. CRSM claimed damages of approximately €92m for deceit, or alternatively under the Misrepresentation Act.

The notes had CDO's embedded within them which gave exposure to the credit risk of a pool of reference assets through a portfolio credit default swap. A number of the reference assets themselves included further CDOs, each of which was in turn referenced to another pool of credit default swaps (" CDO²").

CRSM intended to hold the Notes until maturity (ranging from 5 to 7 years) – the key risk for CRSM was the risk of default of the CDO²s as a result of the occurrence of sufficient "credit events" in relation to the entities named in the portfolios underlying the CDO²s.

In early 2005 CRSM became concerned that the credit risk of the CDO²s may be higher than it had previously thought. Barclays recommended that CRSM restructure the CDO²s which took the form of substitutions of some of the reference entities in the portfolios and other structural changes to the CDO²s. Of the three CDO²s embedded in the notes, Barclays subsequently agreed to repurchase two from CRSM. The third CDO² in time lost its entire value.

CRSM claimed that Barclays sold the notes on the basis of an agreed AAA rating which they intended CRSM to rely upon as an indication of minimal risk whilst Barclays knew and intended that the instruments they had structured were in fact far riskier than the credit rating indicated. This was because Barclays' internal financial model indicated that at their dates of issue the CDO²s had a far higher probability of default over their lives than would have usually been expected of a AAA instrument. CRSM also claimed that the effect of the restructuring (in particular the substitution of entities with higher spreads) was (to Barclays' knowledge) to increase significantly the risk to which CRSM was exposed – thereby reducing the value of CRSM's investments and enabling Barclays to extract further profits.

CRSM claimed that Barclays had used a practice which it described as "credit ratings arbitrage" with the intention of (a) obscuring the actual risk of the instrument and (b) creating an instrument whose actual risk of default was far higher than its AAA rating implied. The result of this "credit ratings arbitrage" was that Barclays was able to book large profits from the transaction.

Misrepresentation claims

The alleged representations (contained in certain fact sheets and alleged oral statements) made by Barclays which induced CRSM to purchase the notes were (1) that the CDO² notes had a very low risk of default and (2) that Barclays believed and expected the CDO²s notes to have a very low risk of default.

Hamblen J found that no representations had been made to the effect claimed by CRSM. A generalised statement that an instrument had a very low risk of default was an inherently unlikely statement to be made, as both parties would have appreciated that no one can know what the default risk of an instrument actually is. It was also inherently unlikely that a selling bank would make a generalised statement that an instrument had a very low risk of default given the care that is generally taken concerning representations and about the reliance to be placed upon them. Hamblen J also found that no generalised statement as to default risk had been made in the fact sheets.

The Judge also found that the statements made by Barclays that the notes had been rated AAA by one of the credit rating agencies did not imply anything more than that the notes had been rated AAA by that agency. The credit rating agencies' definitions and methods were publicly available and the rating was merely a statement of the rating agency's expert opinion.

Hamblen J also found that Barclays did not (as was alleged) attempt to conceal the fact that in the restructuring it was selecting substitutions with higher spreads. The decision to select substitutions with higher spreads was a legitimate means to build in some profit for Barclays and the relevant Barclays employee did not think of that in terms of any increase in credit or default risk.

Ratings "arbitrage"

Hamblen J found that the purpose of the Barclay's internal model was to calculate pricing; the implied probability of default derived from the pricing model did not provide a reliable measure of probability of default and that on any view that was a reasonable view for Barclays (and other banks) to have taken at the time. One of the key factors in Hamblen J's finding was that the credit rating agencies, being the industry experts, regarded historically derived default data as the most reliable information to be input into their rating models and they regarded the output as being appropriate, reliable and fit for purpose.

The fact that the average credit spread was higher than the average for the ratings category was a normal part of the trade. It was the arbitrage that the CDO business was based on. The profits made by Barclays were not understood to be abnormal and expert evidence indicated that the output of the internal model was not inconsistent with the AAA rating as "the two things were entirely different".

Contractual defences

The Judge also evaluated a contractual clause whereby CRSM had stated that they had assessed and understood the merits of the transaction and that CRSM "understand and accept the...risks of entering into" the notes. Hamblen J held that if the substance of a claim for misrepresentation was that representations were made which led CRSM to misunderstand the risks of entering into the transaction(s) then such claim(s) would be precluded by this clause. However, the nature of the restructuring claims was that the alleged representations made were statements as to the criteria to be applied in carrying out the alleged restructuring. Accordingly, no contractual estoppel arose in respect of these claims.


Although it must be viewed in the context of its own facts, the judgment will be regarded as encouraging by financial institutions involved in the sale of structured products of this nature. In particular, the acknowledgement of the specific purposes of internal pricing models, the legitimacy of ratings arbitrage and the efficacy of contractual liability exclusions will be welcomed by those institutions facing misselling claims.

Ed Sautter
Tel: +44 20 3130 3940

Piers Elliott
Tel: +44 20 3130 3203