Banking litigations in Switzerland because of Lombard loans?
Whenever there are significant corrections in the financial markets there are news about Lombard loans and margin calls related to such loans. This has been so in the context of the so-called Dot-com bubble, the financial crisis of 2007-2008, and this is also true now following the recent severe market correction.
In this article, I would like to briefly discuss (i) how Lombard loans work, (ii) how widespread they are in Switzerland, and (iii) what legal disputes might arise in this context.
How do Lombard loans work?
In my own words, and simplifying the issue for the purposes of this contribution, Lombard loans are loans extended by banks to their customers, which are secured by the customers’ securities held in safe custody accounts administered by the lending banks.
Customers of Swiss banks often not exclusively have a checking account at their bank but also, if they wish to invest in securities, a safe custody account that is administered by their bank. Save for rather rare exceptions, when customers of Swiss banks wish to invest in the financial markets, for instance in the form of buying stocks, they do so by placing purchase and/or sales orders with their bank. The customers then hold the securities purchased via their bank in their safe custody account administered by their bank.
As mentioned above, Lombard loans are loans that are secured by securities. In other words, the customer receiving the loan from his or her bank pledges to the bank the content of his or her safe custody account, i.e., the securities in such account. Additionally, the customer and the bank agree on certain contractual terms, such as the bank’s right to sell the securities in certain events and to set off the proceeds from such sale from the outstanding loan amount. Consequently, looked at these agreements not from a legal point of view, but from a result point of view, a Lombard loan has the effect that should the customer-debtor not be able to repay the loan (or, as explained below, to meet a margin call), the bank-creditor is entitled to use the pledged securities to cover the loan.
Usually Lombard loans are used by bank customers to invest the loan amount in securities to take advantage of the so-called leverage effect. The term leverage describes the possibility to increase the return of an equity investment (Eigenkapital) by using borrowed capital (Fremdkapital), which can be illustrated on the basis of the following simple example:
Let us assume an investor invests CHF 40’000.00 in a given security the value of which increases 10%. Such an investor makes a gross gain of CHF 4’000.00. However, if the investor can borrow additional capital of CHF 60’000.00 and then invests his or her equity and the borrowed amount in the mentioned security (total investment of CHF 100’000.00), his or her gross gain (i.e., before deduction of the borrowing and certain other costs) will be CHF 10’000.00, not only CHF 4’000.00. In this example, the investor has increased the gross gain by a factor of 2.5, thanks to leverage, i.e., the use of borrowed capital.
It is important to stress that leverage as described above deploys its effect in both directions, i.e., amplifies gains but also losses. If the performance of an investment is not positive, but negative, such as -10% pursuant to the example above, the unleveraged loss is, according to such example for illustration purposes, minus CHF 4’000.00, whereas the leveraged loss is more important by a factor of 2.5, i.e., amounts to minus CHF 10’000.00 (plus borrowing and certain other costs).
The loss amplification effect of leverage described above, as well as the volatility of certain investments such as equities, requires a bank to ensure that there is a certain buffer that protects its loan. Such buffer is referred to as margin. Regarding the three elements of the example above, i.e., the customer’s equity of CHF 40’000.00, the bank’s loan of CHF 60’000.00, and a total amount invested in securities of CHF 100’000.00, the margin amounts to CHF 40’000.00. In other words, the total value of the investment in securities (CHF 100’000.00) can be reduced by CHF 40’000.00 before that the bank’s loan amount of CHF 60’000.00 is directly hit by any further reduction of the investment’s value, i.e., before that the loan is not covered by pledged securities anymore.
In the Lombard loan agreement, the customer and the bank will agree on the importance of the margin that is at all times to be in place. The mentioned parties will also agree that the bank has the right to require the customer to transfer on short notice additional assets into his or her pledged safe custody account and/or checking account if and when the value of the securities would fall under the agreed margin level or that the falling below the margin level would be imminent. The bank’s request to furnish additional assets is referred to as a margin call.
There are actually quite a number of points that are determined in a Lombard loan agreement, such as, to name just a few, the type of additional assets that the customer may furnish in the event of a margin call, the value that such assets would be attributed to by the bank, the period of time in which such additional assets have to be furnished following a margin call, etc. A crucial aspect that is agreed between the parties, and which is expressly determined in the agreement, is what happens if a customer does not meet a margin call in the required period of time. In relation to such an eventuality, the bank is, in essence, authorized to immediately sell as many securities (or other pledged assets, such as foreign currencies) as is necessary to cover the Lombard loan.
The feature mentioned above, i.e., the bank’s right to immediately sell customer securities to repay its loan in the event that a margin call is not met, can have the effect that the negative performance of an investment is realized. In other words, because of the use of leverage in the form of a Lombard loan a customer may not only experience increased book or accounting losses in a market correction but may, if he or she cannot meet a margin call, have to look at realized losses without the possibility of making up for the accounting losses at a later date.
How widespread are Lombard loans in Switzerland?
Swiss banks have granted significant Lombard loans in the past. There are reports in the media, which state this, such as an article in the Handelszeitung dated 15 March 2020, and this is also indicated by the important amount of such loans outstanding at the most important Swiss private banks, including UBS (Lombard loans of approximately USD 88.7bn as per the end of 2019), Credit Suisse (Lombard loans of approximately CHF 42bn as per the end of 2018), and Julius Baer (Lombard loans of approximately CHF 39.5bn as per the end of 2019).
Lombard loans are attractive from the bank-creditor’s perspective, because they represent a source of income (among other things, in the form of the borrowing costs to be paid by the customer-debtor) and they increase the value of the customers’ securities holdings, which is a key figure for private banks and also increases the banks’ revenues (in the form of increased custody fees). For this reason, it is to be assumed that not only the biggest Swiss private banks extended Lombard loans to their customers, but that also many others, less important Swiss private banks did so.
What legal disputes might arise in the context of Lombard loans?
While Swiss law, obviously, permits the agreeing on and granting of Lombard loans as a matter of principle, including the pledging of assets to secure such loans, significant market corrections in the past have shown that banking litigations may, depending on the circumstances, result from such loans. For example, the Swiss Federal Tribunal (SFT) precedent 133 III 97 dated 4 January 2007 is related to massive losses in the autumn of 2001, presumably triggered by the 9/11 attacks on the US, and the SFT judgment 4A_730/2016 dated 5 February 2018 concerns margin calls made in September 2008, when the financial crisis of 2007-2008 peaked.
Past litigations concerning Lombard loans have shown that different aspects related to such loans may be disputed among the parties, among them the two typical issues briefly discussed below.
One point that has been argued by bank customers in the past is that they had not been duly informed by their bank about the risks related to Lombard loans. Concerning the banks’ duty under Swiss law to inform their customers about the risks of certain financial transactions there is an abundant amount of jurisprudence and doctrine that deals with this issue. With regard to Lombard loans, the basic principle is that the bank has an increased obligation to inform its customer about the relevant risks when the customer uses a loan extended by the bank to increase his or her exposure. That said, if and when a bank customer knows the risks related to a certain financial investment, including the use of leverage, he or she must not be informed about such risks by the bank. The SFT has confirmed this in different judgments, for instance in its decision 4A_449/2018 dated 25 March 2019 (consideration 5 in fine):
“Die Aufklärung des Kunden durch den Beauftragten hat jedoch keinen Selbstzweck, sondern dient dazu, Informationsdefizite auszugleichen. Kennt der Kunde die Risiken der Spekulationstätigkeit, braucht er keine Aufklärung…”
“However, the information of the customer by the bank is not an end in itself, but serves to compensate for information deficits. If the customer is aware of the risks of speculative activity, he or she does not need to be informed…” (tentative English translation by the author)
Specifically in relation to Lombard loans, a fully informed bank customer has been identified for example in the SFT decision 4A_730/2016 dated 5 February 2018 (consideration 3):
“Selon des constatations du Tribunal civil que la Cour d’appel confirme de manière au moins implicite, le demandeur avait parfaitement compris et accepté le risque inhérent aux crédits ‘lombard’, c’est-à-dire le risque que l’emprunteur ne soit pas en mesure de donner suite à un appel de marge, que les valeurs remises en nantissement soient par conséquent aussitôt vendues nonobstant une conjoncture défavorable, sans possibilité d’attendre un redressement des cours, et qu’il en résulte une perte.”
“According to the findings of the Civil Court, at least implicitly confirmed by the Court of Appeal, the claimant had fully understood and accepted the risk inherent in Lombard loans, i.e., the risk that the borrower would not be able to meet a margin call, that the pledged securities would therefore be sold immediately despite unfavourable market conditions, with no possibility of waiting for prices to recover, and that this would result in a loss.” (tentative English translation by the author)
The question of whether a bank customer was already aware of Lombard loan-related risks or was duly informed by his or her bank about such risks is, of course, to be determined in light of all the relevant circumstances of a specific matter. That said, given the strict information obligations formulated by the jurisprudence of the Swiss courts as well as practical experiences gained by Swiss banks following significant market corrections in the relatively recent past, it would be rather surprising if such banks did, save for exceptions, not duly inform their relevant customers about the functioning and risks of Lombard loans.
Another point that gave rise to disputes in the past is whether or not banks complied with the Lombard loan agreement when issuing margin calls and, not having obtained additional collateral, thereafter selling the assets held in the clients’ safe custody accounts. For example, in a SFT decision 4A_521/2008 dated 26 February 2009, it had been retained that the selling of pledged securities had been carried out in breach of the Lombard loan agreement by the bank, given that it had omitted to submit a margin call to its customer (at consideration 7.2):
“Aus dem festgestellten Sachverhalt geht nicht hervor, dass die Beklagte dem Kläger zwischen dem 13. und 21. September 2001 eine Frist zur Nachdeckung angesetzt hätte. Wie die Vorinstanz zutreffend erkannte, ist die Privatverwertung am 21. September 2001 unter diesen Umständen vertragswidrig erfolgt.”
“It is not apparent from the facts established by the lower court that the defendant set the claimant a deadline between 13 and 21 September 2001 to furnish additional collateral. As the lower court correctly recognized, the selling of assets on 21 September 2001 was in breach of contract under these circumstances.” (tentative English translation by the author)
It goes without saying that banks, when issuing margin calls and/or selling pledged securities under Lombard loan agreements, have to ensure that all provisions contained in such agreements are strictly adhered to, and that this is properly documented, also in times of high volatility, time pressure, and stress. As could be seen in the past, periods of significant asset destruction tend to “produce” legal disputes in the aftermath of such events. In such disputes, the smallest details may, depending on the circumstances, come under intensive scrutiny and play significant roles, such as the exact formulation of written communication between banks and their customers or, to give another example, at what time, which price and which exchange a certain security was sold. From the banks’ perspective, it is important that high attention is given to all relevant points and that all steps are properly documented.
Philipp H. Haberbeck, Zurich, 23 March 2020 (www.haberbeck.ch)
The information contained in this post is for general informational purposes only and is not intended to constitute legal advice. Readers of this post should not take any actions or decisions without seeking specific legal advice. Any mandate is subject to the full execution of an engagement letter.
Rechtsgebiete: Bank- und Finanzmarktrecht