Deutsche Bank Loses First German High Court Case Over Swaps

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Deutsche Bank AG, Germany’s biggest bank, lost a case over interest-rate swaps in the first ruling by Germany’s highest court concerning sales of the products that have spurred lawsuits against lenders throughout Europe.

The bank must pay Ille Papier Service GmbH 541,074 euros ($770,000) plus interest over the swap purchase, Federal Court of Justice Presiding Judge Ulrich Wiechers said. The bank didn’t adequately disclose the risks of the products, he said.

“As an adviser to its customer, the bank must guard the customers’ interest alone,” Wiechers said in Karlsruhe, Germany, today. “But as a seller of the swap, a loss to the customer works to the banks’ advantage.”

The ruling will influence dozens of disputes Deutsche Bank has with local German governments, community-owned utilities and companies that claim the lender sold swaps without adequately disclosing risks and fees for the products that were designed to lower interest payments. Cases over derivatives sales have spread throughout Europe with similar disputes in Italy, France and England.

“The floodgates are open,” said Michael Dempster, founder of the University of Cambridge’s Centre for Financial Research in the U.K., who is working with law firms, including the lawyers for Ille Papier, representing German municipalities in swaps cases. “Every bank was doing this and not just in Germany.”

‘Risk Provisions’

Deutsche Bank lawyer Christian Duve said his client needs to analyze the written ruling. The “number of open disputes over these swaps is limited,” he said. “The bank has taken adequate risk provisions for this.”

Olaf Kayser, an analyst at Landesbank Baden-Wuerttemberg, estimates swap-related suits may cost Deutsche Bank a “mid double-digit million euro sum.”

“I think the damages for Deutsche Bank are relatively limited because the bank has already won or reached settlements for the majority of such cases,” Kayser said. “These cases could damage the bank’s reputation.”

Deutsche Bank’s maximum exposure from the suits would be “substantially” less than 100 million euros, Deutsche Bank spokesman Ronald Weichert said. Shares of the bank fell 7 cents, or 0.2 percent, to 41.13 euros in Frankfurt trading.

Deutsche Bank, which acted as Ille Paper’s adviser, had the duty to disclose an initial negative market value of about 80,000 euros that covered the lenders profit and costs, because it was a crucial indicator how chances and risks were structured into the product, Wiechers said today.

Negative Market Value

“The bank consciously structured the risk to its own advantage and at the expense of its client to be able to sell that risk to the market,” said Wiechers. “The negative market value, consciously structured by the bank, was a manifestation of a grave conflict of interest.”

The bank also didn’t adequately explain the risk, according to the judge. It wasn’t enough to tell Ille Papier that it could “theoretically” face unlimited losses.

“The court very well exposed the structure of the product and the conflict of interest problem,” said Jochen Weck, a lawyer for Ille Papier.

There are eight cases pending at the top court and 17 in lower courts over the same type of derivative, according to Deutsche Bank.

‘Greater Transparency’

Banks may fare better in the U.K., where dozens of swaps cases have been filed. Barclays Plc earlier this month won a case filed by Cassa di Risparmio di San Marino and in 2009 two Norwegian towns were ordered to pay Depfa Bank Plc about 425 million kroner ($76 million).

“The more interesting question is what happens when banks specifically exclude that they act as an adviser, said Dario Loiacono, who represented San Marino. “This judgment seems to confirm that bank must act in the interest of the client, irrespective of how sophisticated the client is. It defeats the premise of caveat emptor.”

In Italy, municipalities face derivative losses of at least

1.2 billion euros, Bank of Italy data from June 30 show.

Today’s case centers on a derivative Deutsche Bank branded as a “CMS Spread Ladder Swap.” Under its terms, the lender agreed to pay its customer 3 percent interest on 2 million euros for five years. The customer had to pay the bank 1.5 percent during the first year and later a variable rate based in part on the spread between two-year and 10-year Euribor rates.

The court rejected Deutsche Bank’s argument that every high school graduate could calculate the formula the swap was structured on. It wasn’t enough to explain the steps of the mathematical operation unless the banks also explained what risks it entails, Wiechers said.

Formulaic Poems

“Let me put it this way: If you are able to read the words of a poem, you haven’t necessarily also understood its meaning,” said Wiechers. “That also applies to this swap’s formula.”

At the February hearing the lender’s lawyer, Reiner Hall, said that if the court required banks to disclose their profit margins, they could cause a new financial crisis. Such a ruling could cost the industry “billions of euros,” said Hall.

Wiechers rejected that argument today, saying as a rule, banks don’t have to disclose profit margins. The swap in today’s case required disclosure of profit margins because it involved greater conflict of interest between the bank and customer, according to the judge.

Profit Disclosure

“It’s clear that as a general rule banks don’t have to disclose their profits if they sell products,” said Lars Kloehn, a law professor at Germany’s Marburg University. “They do have to disclose them if additional circumstances apply, for example when banks act as investment advisers and sell products that they have deliberately structured to the detriment of the customer.”

Ille Papier, based in Altenstadt, Germany, sells toilet paper, paper towels and disposal systems for bathrooms. The hygienic paper brand is often seen in bathrooms at service areas along Germany’s autobahns.

In February 2005, Deutsche Bank advised Ille Papier to buy the CMS swap based on its expectation the spread would widen and the customer would make money. The lender hedged its risks on the deal through options.

The spread narrowed in the second half of 2005 and Ille Papier lost money. The company and Deutsche Bank agreed in 2007 to terminate the contract for a payment Ille Papier now seeks to recover. The bank won dismissal of the suit in lower courts.

The German city of Pforzheim filed an action against JPMorgan Chase & Co. in December over 56 million euros in losses, making claims similar to those in the top court suit.

Deutsche Bank won a majority of decisions on the swaps issue in German state appeals courts while a minority held the lender violated its duties to customers when selling the swaps and ruled, at least in part, against the bank.

The case is BGH, XI ZR 33/10.

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