AP-Fonden v Bank of New York Mellon SA/NV & Ors

A securities lending agent must exercise the contractual standard of care when selecting and managing collateral investments. Investment guidelines define the agent’s mandate, but compliance with those guidelines does not prevent a separate challenge based on negligent performance.

The agent must monitor the account for ongoing compliance where the agreement requires management of the collateral account. A liquidity restriction may apply at acquisition without requiring disposal merely because an investment later becomes illiquid.

Where the agent communicates with a client about a serious risk of loss, it must present the risk and available alternatives fairly. Reassurance inconsistent with the agent’s own assessment may constitute breach of duty and negligent misrepresentation.

Första AP-fonden, a Swedish pension fund, appointed the Bank of New York Mellon to manage its securities lending programme and reinvest cash collateral. The bank acquired Sigma Finance medium term notes for AP’s segregated account. Sigma later became exposed to the financial crisis, increased its reliance on repo financing, lost its AAA rating and ultimately defaulted.

AP claimed that the acquisition and retention of the notes breached the Securities Lending Authorisation Agreement, the bank’s duties of care and fiduciary duties, and applicable best-execution obligations. It also alleged that the bank’s communications in May 2008 understated the risk of default and failed to explain alternatives to holding the notes to maturity.

1. Acquisition and retention. AP’s claims concerning acquisition and retention were dismissed. The Sigma notes were permitted asset-backed securities, rated AAA when acquired, and were liquid within the contractual definition at that time. The acquisition was therefore within the bank’s mandate. The bank nevertheless remained subject to the contractual standard of care in clause 10(b)(i) of the Securities Lending Authorisation Agreement.
2. Construction of the guidelines. The objective of safeguarding principal described the purpose of the account but was too vague to define the bank’s mandate independently. The operative mandate was defined by the detailed provisions governing eligible instruments, ratings, maturity and diversification. The bank had an ongoing duty to monitor the account and credit quality. The 40 per cent limit for floating-rate securities applied on an ongoing basis. The prohibition on illiquid securities applied at acquisition, not continuously, and did not require a forced sale after later market illiquidity.
3. Fiduciary duties. A global custodian or securities lending agent may be fiduciary in respect of particular activities, but the contractual relationship and the specific duty alleged must be examined. The pleaded complaints principally concerned competence and communication, and were negligence claims rather than breaches of fiduciary duty.
4. Repo financing and risk. Repo transactions subordinated senior noteholders to repo counterparties and materially weakened the protection provided by Sigma’s asset portfolio. The bank’s monitoring was vigorous, but its analysis did not adequately assess the effect of repo financing in a liquidation.
5. May 2008 communications. Once the bank contacted AP about the serious risk affecting Sigma, it had to communicate fairly under its contractual and tortious duties of care. It told AP that it remained confident of repayment, although its internal analysis and communications with other clients identified a significant likelihood of default and diminished principal repayment. It also failed adequately to explain the ratio-trade alternative. These communications were misleading and negligent.
6. Causation and result. AP relied on the defective communications. Had it received a fair account of the risk and alternatives, it would have exited its Sigma exposure. The loss was foreseeable and was not caused or contributed to by AP. AP succeeded on the communications claim and was entitled to judgment; quantum was left for agreement.