Nedbank hit first in legal war with Absa

One of the curious legacies of the financial crisis is a quiet legal fight between Absa and Nedbank. Absa is demanding Nedbank pay it R773m to put right losses it incurred in 2008 after it landed up as the owner of some very toxic assets.

That is after Absa unwittingly ended up as the guarantor of Cortex Securities, a fly-by-theseat-of-its-pants derivatives trader. Cortex had cooked up a scheme by which owners of small JSE-listed companies could get cash from their illiquid holdings by swapping the shares for single stock futures.

They could maintain their economic exposure to the stock but would get up to 90% of the value of the underlying shares in cash immediately.

Nedbank stepped up to the plate as a counterparty to Cortex. It took the shares to hold as security and wrote futures that Cortex clients would hold. In theory, when the future expired, Nedbank would deliver the shares back to the client in return for an agreed price, which would include interest.

The clients need only put down “margin”, a deposit on the value of those shares equivalent to about 10% but, crucially, that margin had to be maintained over time. So if the value of the shares fell, clients had to deposit more.

Absa found itself asleep at the wheel, unaware of the large risks mounting at Cortex. It became hugely problematic in one particular company, a developer of golf courses called Acc-Ross, which changed its name subsequently to Pinnacle Point. Its shareholders had been big fans of Cortex’s scheme, so much so that at one point Nedbank was holding 89% of all of the Pinnacle Point shares in issue as security against futures it had written.

The problem, as has now become clear, is that all kinds of games were being played with the Pinnacle share price. The shareholders used the cash they had received by swapping the shares for futures to buy more shares, so keeping the share price up.

Cortex traders and some of the underlying shareholders, since fined by the Financial Services Board up to the maximum allowable R10m, also intervened at market close to push up the closing price. All this had the effect of saving the shareholders from margin calls that they could not afford to pay.

It all worked until the financial crisis-induced market collapse meant they just could not resist the selling pressure any longer. Once the first margin call came, it all collapsed like a house of cards.

Cortex’s clients could not meet the margin calls and neither could Cortex, leaving Absa with a very big bill to pay.

Nedbank was arguably aware all this was going on but it effectively faced no risk. It knew Absa was standing behind Cortex, so if it all crashed Absa would have to step up to settle the obligation. In the mean time it could write the futures and earn good fees and interest.

Absa’s claim has two main thrusts, firstly that Nedbank broke the rules. It argues Nedbank broke JSE rules in that it was assisting with the creation of a false market for Pinnacle Point shares. It also failed to disclose its growing holding of the shares as it arguably was required to do in terms of Securities Regulation Panel rules of the time, as well as the Banks Act and Competition Act.

Absa also argues that Nedbank has a common-law duty of care to Absa not to expose it to harm recklessly.

The first set of arguments will turn on technical interpretations of the legislation and rules.

The second is about the spirit rather than letter of the law, and could set long-term precedents for what should be expected of banks. It is a claim that banks have a legal responsibility to be trustworthy. This draws on the rather ancient legal idea of “delict”, a duty of care to others. This set of arguments has had the most airing so far in the fiveyear-long litigation, and it came out badly for Nedbank. It had filed an exception application arguing there was no legal basis for Absa’s claim and it should be dismissed without going to trial.

Nedbank argued Absa was a big boy and should be willing to roll with the punches if it wants to be in the playground. Absa “was in for the profit, and risks go with profit”.

Nedbank lost the exception application in February, meaning the case now will go to trial.

The judgment on the application has some interesting morsels. The parties seem to agree Nedbank’s actions correctly incite moral indignation; the disagreement is whether this is a legal and not just moral issue. The judge rejected Absa’s opinion that Nedbank implemented the scheme “with exuberance born of the miracle of profit without risk” as well as Nedbank’s submission that Absa was suing it because it was the one party in the mess with “deep pockets”. There is a legal case to be answered because Nedbank was under a legal duty not to act as Absa alleges it did, the judge determined. This is not a finding on the facts, but merely that there is an issue in law at stake. When the facts can be assessed, the findings will be very interesting indeed.

IT IS A CLAIM BANKS HAVE A LEGAL RESPONSIBILITY TO BE TRUSTWORTHY. THIS DRAWS ON THE IDEA OF A DUTY OF CARE