Case Study - Client Classification: Rafed Al Khorafi and Others v Bank Sarasin-Alpen (ME) Ltd and Bank Sarasin & Co Ltd
In a ruling with broad consequences for the international investment community, the Dubai International Financial Centre (‘DIFC’) Court has ordered Switzerland’s Bank Sarasin and its affiliate to pay compensatory damages to the family of Kuwaiti businessman Rafed Al Khorafi for the sale of inappropriate structured real estate-, commodity-backed and equity sector basket instruments in late 2007- early 2008. Based on DIFC law, the court concluded that Bank Sarasin had committed “a clear case of mis-selling unsuitable investments to an unsophisticated investor . . . without regard to the protection that the Regulatory Law was intended to afford Retail Customers“. The suit, initiated five years ago after the 2009 world economic collapse led the Al Khorafi Family members, who were represented by KBH Kaanuun, to default on obligations arising under those investments, presents an important milestone in the allocation of risk between retail clients and vendor banks in transactions involving structured products and illustrates how and when the courts make best use of expert testimony in deciding key issues in such disputes.
At issue was the Al Khorafi Family’s purchase of some $200 million in structured instruments which, according to the Family, were sought in order to meet specific financial objectives.
Using monies borrowed from the Al Ahli Bank Kuwait (‘ABK’), ultimately combined with other loans from Bank Sarasin, Rafed Al Khorafi, his mother and sister (‘the Al Khorafi Family’) wished to purchase investment instruments which guaranteed that they would not lose capital, that would provide income to pay the on-going interest owed on the ABK loans, and which would return them a profit on the overall investment at the end of the contract.
In 2007, the investors engaged in discussions with Bank Sarasin through it’s Middle East wealth management and marketing affiliate, Bank Sarasin-Alpen (hereinafter collectively ‘Bank Sarasin’) to identify an investment product or strategy that would meet those requirements.
Bank Sarasin-Alpen was created to do business within the DIFC, and so was subject to Dubai Financial Services Authority (‘DFSA’) regulation. Mr Al Khorafi was assured by Mr. Rohit Walia (Chief Executive Officer of Sarasin-Alpen) that the Bank could create structured financial products that, if held to maturity, would contain was no risk of capital loss and meet the family’s other requirements including capital profits leading up to and upon maturity.
The products Bank Sarasin offered were “baskets” of, inter alia, Real Estate Investment Trusts (‘REITs’), equity sectors and commodity holdings (collectively ‘the Sarasin Notes’). These investments were made in three tranches, each containing differing instruments. Walia convinced the Al Khorafis to follow through on the investments based on the representations that the Al Khorafis could not lose their initial capital investment and, indeed, based on the Bank’s track record of making profits for clients up to 50% profit per year, would probably not have to wait the full three-year term of the contracts before cashing out.
There still remain three studies suitable for free man. Arithmetic is one of them.”
Plato
In the autumn of 2008 the world financial crisis devalued the investment portfolio created for the Al Khorafis, and to make up the resulting collateral shortfall in the family’s investment Bank Sarasin issued a margin call. The Al Khorafis failed to meet the call and thus defaulted on both their Bank Sarasin and ABK loans, suffering losses claimed of $26.8 million.
The family sued Bank Sarasin for damages equal to those losses in the DIFC courts, and while the claims included common law contract and tort theories, the main thrust of the court’s decision addressed DIFC regulatory requirements of Bank Sarasin when engaging in such transactions with investors.
Regulatory Violations
The case effectively revolved around the financial sophistication of the Al Khorafi Family. DFSA law required Bank Sarasin-Aspen to independently determine whether the Mr. Al Khorafi, his mother and sister were “Clients” or “Retail Customers” under DFSA regulations. Within the DIFC’s exclusively wholesale business zone, Bank Sarasin-Alpen was barred from dealing “with or for a Retail Customer” and could only offer financial services or products to “Clients” of sufficient expertise or experience to participate in the large and complex financial transactions encouraged within the DIFC. “Sophistication” under the law is defined as an individual who:
1. has at least $1 million in liquid assets and has provided the Authorised Firm with written confirmation of this fact;
2. appears to the Authorised Firm, after analysis, to have sufficient financial experience and understanding to participate in financial markets; and
3. has consented in writing to being treated as a Client.
It appeared to the court that only this last condition might have been satisfied by Bank Sarasin, as Bank Sarasin failed to conduct the requisite research to justify the conclusion that the family members were “Clients” under the DFSA. As part of the account-opening process, Mr. Al Khorafi and his family had executed Agreements of General Business Conditions which included terms by which they warranted that they were Clients as defined by the DFSA, but the documents were not completed in several important regards and the court concluded that, even if the investors had completely filled in the forms, the bank did little to nothing to verify those representations or whether the document itself was understood by the Al Khorafi,et al. Moreover, the facts supported the conclusion that Bank Sarasin-Alpen had determined the Mr. Al Khorafi and his relatives were Clients even before meetings at which information supporting the decision was supposedly discussed. (This was a problem with Bank Sarasin-Alpen’s case throughout the proceedings, as officers of the bank consistently offered vague, evasive or conflicting testimony concerning their dealings with Mr Al Khorafi).
Consistency is found in that work whose whole and detail are suitable to the occasion.”
Vitruvius
Ultimately, the bank seemed to be comfortable relying upon the Al Khorafi Family’s historical involvement in financial matters, including a role as co-founders of the Bank of Kuwait, and some “internet research” to ascertain the financial acumen of the family in general. Such historical credits were not specific to Rafed Al Khorafi or his mother and sister, and the bank’s failure to investigate their individual sophistication led the court to conclude that Bank Sarasin had not acted with due diligence, and that Mr. Al Khorafi, his mother and sister were not Clients under the DFSA. Bank Sarasin-Alpen had thus violated DFSA law entering into a prohibited contract for financial services with a Retail Customer.
Contract Claims
The conclusion that Bank Sarasin’s dealings with the Al Khorafi Family was a prohibited transaction under the Financial Services Prohibition in DFSA Article 41 was legally sufficient to dissolve the agreements between the Al Khorafis and Bank Sarasin, but the court went on to consider if Mr Al Khorafi et al had been Clients under the DFSA. If they were, then Bank Sarasin’s performance under the Sarasin Notes constituted a breach of contract; Bank Sarasin breached DFSA Conduct of Business (COB) Rule 6.2 in recommending a transaction or transactions to them without regard to their investment objectives, risk tolerance or any other requirements of which Bank Sarasin was or ought reasonably have been aware.
The court’s determination that Mr. Al Khorafi was not in fact a “Client” under DFSA law fell clearly within the court’s fact-finding function and its obligation to construe the law. The legal question of the suitability of the Sarasin Notes to the family’s investment needs, however, hinged on calculations of function and risk presented by those structured products and what Bank Sarasin- Alpen did to inform the family of those risks. As the court cited;
the proper role of the expert witnesses, under this head, was to assist the Court in identifying the risks to which the Claimants were exposed in purchasing the investments which they did – and, in particular, the risks inherent in purchasing those investments with funds borrowed from ABK and Bank Sarasin (in the latter case, by way of leveraging) – and the extent to which an Authorised Firm in the position of Sarasin-Alpen, exercising reasonable skill and care, could have been expected to draw those risks to the attention of the Claimants and advise upon them. It is not the proper role of an expert to decide the question “were the investments suitable: that is for the Court“.
Court decision at paragraph 348.
Both sides offered expert testimony, but both experts offered different approaches to their assignment. Bank Sarasin’s witness, a former trader, based his testimony on the premise that only the investor could decide whether a given instrument was suitable to his financial goals. He then testified about how the Sarasin Notes could have been so accepted by the Al Khorafis given the instruments’ specific qualities. These conclusions were not surprising to the court, given that the witness had experience in the industry only as a trader, and that “that he had never, in his professional career, had occasion to give advice to a retail client, or to give advice in the context of a suitability requirement“. Since the DFSA regulations specifically made it the burden of the financial institution to determine suitability of a given investment for a Client, the expert offered no insight into how a bank or financial advisor would normally be expected to meet that responsibility, and his testimony was considered of “little assistance” to the court.
Dr Thomas Walford, testifying and instructed by the Al Khorafi Family, took a more objective view of the transactional requirements under the DFSA. In looking at the Sarasin Notes, Walford identified at least six areas of significant risk of which the Al Khorafis would have to have notice in order to assess the appropriateness of the investment, including risks that the investments might not produce sufficient return to meet the financing costs associated with the leveraging provided by Bank Sarasin and the interest payable on the ABK loans, and that a fall in value of the leveraged investments would trigger a margin call requiring the immediate payment of substantial collateral. A failure to pay margin call would result in early liquidation of the totality of the investments, exposing the Claimants to a potential capital shortfall with regard to their ability to repay the ABK lending and/or the Bank Sarasin lending. Moreover, without very significant capital growth over the course of the investments, there was a likelihood that there would be insufficient funds at the end of the period to pay out the Claimants in full; and so a risk of capital loss.
This and other factors led Dr. Walford to testify that the Al Khorafi-Bank Sarasin transactions were “doomed to failure” from the outset and likely to lead to losses even in normal market conditions. Walford further advised the court that the complex and derivative nature of the Sarasin Notes did not make any of these and other risks easy for an investor to recognize, and that a bank acting according to acceptable industry trade and practice would have advised its customers of those risks. Based on Walford’s testimony, the court concluded that, if it is assumed that the Al Khorafi Family had been Clients under DFSA regulations, Bank Sarasin-Alpen breached its contract with the Al Khorafi investors by failing to act as an adviser exercising reasonable skill and care when selling the family financial products. In the court’s estimation, Bank Sarasin-Alpen had two choices: to advise the family of the true risks of the investment up front, or to admit that the bank had no investment opportunity which met the their needs of guaranteed capital with the indicated stream of income.
An investment in knowledge pays the best interest.”
Benjamin Franklin
As a final note, the court briefly considered the Claimants’ common law tort claims based on fraud raised. Aside from the issue of whether the laws of Switzerland or Kuwait governed the claims, Mr. Al Khorafi and his relatives had prevailed on the statutory and contract claims; tort claims added little to their success, and the court dismissed them, finding in fact that there had been no affirmative misstatements or other fraudulent representations made by Bank Sarasin-Alpen in its advice to them. The court did not make a specific calculation of the damages owed, but the actual losses to Mr. Al Khorafi and his family from the Sarasin Note failures was not in dispute. Bank Sarasin-Alpen is considering its appeal options following the court’s decision.
Conclusions
The DIFC court ruling in the Al Khorafi v. Bank Sarasin case offers financial experts a window into the fluid nature of institutional obligations in complex derivative transactions. In simplest terms, banks and other investment advisors, for at least under DFSA rules, need to collect information concerning investor qualifications and sophistication. Because this case involved a number of international players, the standards of conduct applied by the court and experts testifying before it may be easily adopted by jurisdictions beyond the DIFC.
The Al Khorafi decision also makes it clear that, as structured products become increasingly complex, so does a bank or broker’s obligation to spell out the real and practical implications of special terms within the instrument. Terms like “capital guaranteed” within one area of the market may mean one thing to one professional client and quite another to one of lesser or different experience. An expert called upon to assist sellers, buyers or courts making decisions in the field of sophisticated international finance needs to make sure that he is testifying regarding transactions with which he has substantial and specific experience or expertise, and that his testimony takes into account current and emerging standards of conduct with respect to specific financial transactions.
This case is likely to have far reaching implications. Bushra Ahmed, Head of Dispute Resolution at KBH Kaanuun commented that “this case will be scrutinised and analysed by all practitioners across the common law world from Hong Kong to New York. It will be of significance to High Net Worth individuals, hedge and mutual funds and financial institutions who engage in selling complex structured products to retail investors.”
Counsel: Mr Richard Hill QC and Mr Sharif Shivji instructed by KBH Kaanuun for the Claimants.
Mr Michael Brindle QC instructed by Al Tamimi & Co for the First Defendant.
Mr Michael Black QC instructed by Al Tamimi & Co for the Second Defendant.
Link: DIFC Courts – CFI 026/2009 Rafed Al Khorafi v Bank Sarasin-Alpen (ME) Ltd