Financial engineering and banking liability

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Sophisticated financial arrangements, often referred to as financial engineering, have become commonplace in the banking world. While they offer opportunities, they also entail significant risks, both for customers and for lending institutions. It is therefore essential to understand the mechanisms involved and the contours of the associated banking liability.

Definition and context of financial engineering

What is banking financial engineering?

Banking financial engineering refers to all the sophisticated techniques and packages developed by financial institutions to meet their customers' specific financing objectives. The aim is to create tailor-made products that combine different financial instruments to optimise taxation, control financial management, maximise returns or reduce financial risks. These packages are generally characterised by their complexity and the combination of several interdependent contracts, sometimes in an international context.

At the heart of this practice lies the creation of value through the intelligent articulation of different legal mechanisms and financial techniques. Far from being a simple juxtaposition of standard products, financial engineering is the result of genuine expertise, which presupposes in-depth knowledge of financial markets and regulations.

Recent developments in the financial packages offered by banks

Since the 2000s, financial engineering products have become increasingly sophisticated. This trend can be explained by a number of factors: financial deregulation, market globalisation, and the constant search for innovation to stand out in a competitive environment that requires greater control over risk management.

Banks have gradually extended their range of services beyond the traditional business of granting credit to offer global solutions that integrate investment, credit and insurance. This development has blurred the boundaries between the various financial activities and made the legal analysis of responsibilities more complex, particularly in the field of corporate and market finance. The liability and financial engineering have thus become central issues.

More recently, the 2008 crisis highlighted the risks inherent in certain arrangements and led to stricter supervision of these practices, without however significantly reducing their diversity, prompting financial management teams to review their optimisation strategy.

The main types of set-up commonly proposed

The most common types of arrangements in the banking sector are :

• Loans earmarked for financial investments: the institution lends funds to be invested in financial products, in the hope that the return on the investment will exceed the cost of the loan, a form of equity strategy.
• Term loans backed by life insurance policies: the customer takes out a loan for which only the interest is repaid during the term of the loan. The capital is repaid at maturity thanks to the value of a life insurance policy taken out at the same time and generally pledged to the bank.
• Structured loans: loans where the interest rate conditions are determined by complex mathematical formulae, often indexed to indices or currency parities (such as the Swiss franc), requiring the use of advanced mathematical models.
• Tax-exempt property deals: a combination of property financing with specific tax benefits (Pinel, Robien, etc.), sometimes combined with bullet loans, requiring in-depth study by financial analysts.

The economic context: low interest rates and the search for yield

The prolonged period of historically low interest rates, particularly since the crisis of 2008, has provided particularly favourable conditions for the development of these schemes. In this environment, many investors have sought to increase their returns by leveraging credit.

This dynamic has prompted banks to design increasingly sophisticated products to meet this demand for yield, stimulating trading room activity. The quest for performance in an environment of low interest rates led many investors, sometimes with insufficient training in financial theory, to expose themselves to risks of which they were not always fully aware.

Specific risks associated with financial engineering products

The risks of loans allocated to financial investments

Arrangements combining credit and investment involve a fundamental risk: the performance of the investment may turn out to be lower than expected and may not cover the cost of the credit. This risk is all the greater because the return projections presented at the time of marketing are often optimistic.

The borrower then finds himself in a paradoxical situation where his investment, rather than generating a profit, becomes a source of loss. The main danger lies in the asymmetry of information: while the institution has the expertise to assess the probability of return, the individual investor generally relies on the projections presented to him. In addition, the intrinsic complexity of these structures makes it particularly difficult for a non-specialist to make a fair assessment of the risk/return ratio.

The problem of bullet loans backed by life insurance policies

The combination of a bullet loan and life insurance has a number of specific features, the main one being that there is no gradual repayment of the capital. Throughout the term of the loan, the borrower pays only the interest, while the capital is theoretically repaid at maturity thanks to the increase in value of the life insurance policy.

This structure is based on a risky bet: that the performance of the life insurance policy will be sufficient to cover the capital to be repaid. However, as the financial crisis has shown, this assumption can be derailed, particularly when policies include a large proportion invested in units of account exposed to market fluctuations. The mechanism then becomes particularly perilous.

The hazards of index-linked or structured loans

Structured loans are probably the riskiest category of financial engineering products. What makes them special is that the interest rate is determined by complex mathematical formulae, often indexed to external variables such as currency parities.

The major danger is that it is impossible for the average borrower to correctly anticipate changes in these variables. If the chosen index, which may be a currency, rises by an unanticipated amount, the borrower may find that the cost of the loan becomes significant. This phenomenon was dramatically illustrated by the "toxic loans" indexed to the Swiss franc, which led some borrowers to face rates as high as 15 %, well beyond the initial projections, destabilising their financial situation.

The impact of the financial crisis on these arrangements

The 2008 financial crisis, followed by successive economic turbulences, revealed the vulnerability of these financial arrangements. Three major consequences can be identified:

• The underperformance of investments, particularly unit-linked, making it impossible to repay term loans by increasing the value of life insurance policies.
• Unfavourable movements in certain indices or currency parities led to an explosion in the variable rates of certain structured loans, destabilising the initial financing objectives.
• The collapse of the property market in certain areas, compromising the economic equilibrium of schemes based on rental investments.

These disappointments have led to massive litigation, with disappointed borrowers seeking to hold the institutions behind these arrangements liable, often successfully.

The legal foundations of bank liability

The distinction between the role of simple lender and that of financial services provider

The legal characterisation of the bank's involvement is a fundamental issue in assessing its effectiveness. bank liability. There are two distinct regimes in this area:

• As a simple lender, the bank has relatively limited obligations, mainly based on the duty to warn unsophisticated borrowers.
• As an investment services provider (ISP), it is subject to a much more restrictive set of obligations, stemming in particular from the Monetary and Financial Code and the AMF General Regulation, as explained in our article on the banking liability as an ISP.

The dividing line between these two categories is not always clear. The applicable classification depends in particular on the initiative behind the transaction and the role played by the bank in structuring the arrangement.

The principle of non-interference versus the duty to advise

Banking case law has long been dominated by the principle of non-interference, according to which the bank has no business interfering in its customer's affairs or judging the appropriateness of his economic choices. This principle, which is still regularly invoked, is a traditional obstacle to the recognition of extended obligations on financial institutions.

However, developments in case law show that this principle is gradually being eroded in the face of the emergence of positive obligations, particularly in the area of advice. The tension between these two imperatives - not to interfere but nevertheless to provide appropriate advice - is a feature of contemporary developments in banking law. This dialectic is resolved differently depending on the circumstances, in particular the complexity of the proposed arrangement and the initiative behind the transaction.

Distinguishing between different obligations: information, warnings and advice

Case law has gradually developed a nuanced typology of the bank's professional obligations, distinguishing three levels of increasing intensity:

• Duty to inform: minimum duty to provide objective information on the essential characteristics of the product or service offered.
• The duty to warn: a more stringent obligation to draw the customer's attention to the particular risks involved in the proposed transaction, particularly with regard to the customer's financial situation.
• The duty to advise: this is the most restrictive obligation, and involves providing a personalised recommendation as to the advisability of the proposed transaction.

This seemingly clear distinction gives rise to sometimes confusing applications in case law, with the courts classifying similar breaches in different ways. It is essential to preventing conflicts of interest which may distort the exercise of these obligations. For example, a bank might be tempted to favour an in-house product that is more profitable for it, even if it is not the most suitable for the customer. Similarly, advising a company on a merger while at the same time financing its competitor poses an obvious problem.

The importance of customer qualification (informed/non-informed)

The intensity of the bank's obligations varies considerably depending on whether the customer is considered informed or uninformed. This fundamental distinction determines the existence of the duty to warn.

An informed customer is one who has the necessary skills to appreciate the risks inherent in the proposed transaction. This quality is not automatically deduced from the customer's socio-professional status, but from his or her actual ability to understand the mechanisms involved.

Criteria for assessing bank liability

The complexity of the set-up (ordinary vs complex)

Case law pays particular attention to the intrinsic complexity of the proposed financial package. The more sophisticated the transaction, the more stringent the bank's obligations.

The courts make a distinction between "ordinary schemes", which use classic, easy-to-understand mechanisms, and "complex schemes", which require advanced financial expertise to understand. The latter require the bank to be even more vigilant in the information and advice it provides to its customers. Several decisions have explicitly based the assessment of bank liability on this criterion. This distinction is particularly relevant to hybrid products. The characterisation of an arrangement as 'complex' may thus justify a strengthening of the bank's duties, including towards customers who might be considered informed in a more ordinary context.

The experience and quality of the investor (layman vs. experienced)

Going beyond the binary distinction between informed and uninformed clients, the courts have developed a more nuanced assessment of the client's experience. They take into account the customer's familiarity with the type of product concerned, his investment history and his actual understanding of the mechanisms involved.

This assessment is made in concretoThis will depend on the particular circumstances of each case. For example, the same customer may be considered informed for certain types of transaction and not informed for other, more sophisticated transactions. The burden of proving that a customer is "informed" generally lies with the bank. As the case law points out, this proof cannot be established by deduction or by presumption based in particular on the customer's professional qualities.

The quality of the information provided

The quality of the information provided to the customer is a central criterion in assessing bank liability. The courts carefully examine whether the information was :

• Complete, covering all the essential characteristics of the product.
• Accurate, faithfully reflecting the mechanisms involved and the associated risks.
• Clear, expressed in terms that are accessible to the customer concerned.
• Not misleading, presenting the advantages and disadvantages of the product in a balanced way.

Particular attention is paid to the presentation of risks. The bank must have drawn attention to the characteristics of the product on offer, to the less favourable aspects that could result from price movements and to the fact that the investor could be exposed to a loss of capital. The formality of the information also plays an important role, with the courts checking that the bank is able to prove that the relevant explanatory documents were actually provided.

Whether or not the product offered is speculative

The classification of a product as speculative automatically entails a strengthening of the bank's obligations, in particular the existence of a duty to warn, including towards customers who might otherwise be considered informed.

Case law has gradually refined the criteria for this classification. A transaction is speculative if three conditions are met: the intention of the parties must be to seek a quick profit from an anticipated change in the price of a particular investment; secondly, the context of the transaction must be taken into account; and thirdly, speculation means seeking a short-term gain. For certain products such as UCITS or mutual funds, case law tends to rule out the qualification of speculative product, while transactions on futures markets are generally considered to be speculative.

Consideration of the assembly as a whole (indivisibility)

A significant development in case law is the approach to the package as a whole. Rather than analysing each contract (loan, insurance, investment) separately, the courts are increasingly tending to consider the transaction as an indivisible whole.

This approach provides a more accurate understanding of the economic reality of the arrangement and the associated risks. In addition to the risk associated with the loan, there is the uncertainty of the profitability of the investment, which must be repaid at maturity. Indivisibility may be objective, resulting from the intrinsic characteristics of the transaction, or subjective, resulting from the intention of the parties. The Court of Cassation seems to favour the subjective concept, with indivisibility being deduced "from several elements: their concomitance, the identity of the parties, their common intention". This global approach has important legal consequences, particularly in terms of penalties: the annulment of one of the contracts may lead to the annulment of the entire package.

Developments in case law and regulations

Major seminal case law decisions

Several major rulings have structured the legal framework for bank liability in financial engineering:

• The "Buon" ruling of 5 November 1991 (Cass. com., 5 Nov. 1991, Bull. civ. IV, no. 327), which established the principle of the ISP's duty to warn against the risks incurred in speculative transactions on futures markets.
• The "Bénéfic" ruling of 19 September 2006 (Cass. com., 19 Sept. 2006), which enshrines the general obligation to provide information on the essential characteristics of the financial product offered.
• The rulings of 24 June 2008 (Cass. com., 24 June 2008, RD bancaire et fin. 2008, no. 6, p. 20), which recognise the right of investors to rely on the rules of good conduct set out in the Monetary and Financial Code.

These seminal decisions have gradually built up a body of case law reinforcing the obligations of financial institutions and broadening the basis of their liability.

The gradual strengthening of banks' obligations

There is a general trend towards strengthening the professional obligations of banks. This trend can be seen in particular in :

• Broadening the scope of information to be provided to customers.
• The growing need for advice to be formalised and traceable.
• Extending the duty to warn to an ever-increasing number of situations.
• Recognition, in certain circumstances, of a genuine duty to advise.

This trend in case law reflects the increased need to protect customers in the face of the growing sophistication of financial products. It also reflects a change in the concept of the social role of the bank, which is now seen as a professional with an advisory role that goes beyond the mere provision of financial products or services.

The influence of regulatory authorities (AMF, ACPR)

The regulatory authorities, principally the Autorité des marchés financiers (AMF) and the Autorité de contrôle prudentiel et de résolution (ACPR), are playing an increasing role in defining the professional standards applicable to financial institutions.

Their recommendations, positions and disciplinary sanctions help to clarify the contours of the general obligations set out in the legislation. For example, these authorities have published detailed recommendations on the scope of the duties of insurance intermediaries, investment services providers (ISPs) and financial investment advisers (FIAs). Although not directly binding, these professional standards have a significant influence on case law.

Prospects for changes in banking liability

Several factors suggest that the legal framework for bank liability will continue to evolve:

• The massive litigation surrounding "toxic loans", which continues to produce abundant and innovative case law.
• The growing influence of European law, notably through the MiFID II directive, which strengthens the information and suitability requirements for financial products.
• The trend towards uniform liability regimes applicable to the various players involved in the distribution of financial products (banks, insurers, investment advisers).
• The emergence of new financial engineering products, notably linked to green finance and digitalization, which will raise new legal and ethical issues.

Against this backdrop, we can expect to see a consolidation of the drive to strengthen banks' professional obligations, particularly in terms of the suitability of the products they offer and the quality of the information they provide.

Navigating the complexities of financial engineering and understanding the associated responsibilities can be a daunting task. For an in-depth analysis of your situation and a expert legal supportContact our team of lawyers.

Sources

• Monetary and Financial Code
• Cass. com. 5 Nov. 1991 ("Buon" judgment)
• Cass. com., 19 Sept. 2006 ("Bénéfic" judgment)
• Cass. com. 24 June 2008

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