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Liability of Derivatives Dealers

H. Scott

[The Future for the Global Securities Market 271 (F. Oditah ed. 1996)].

[Derivatives] activity has produced, by some accounts, at least 30 multimillion dollar derivative suits in the United States...by customers against major securities firms that advised them about derivatives or entered into derivatives transactions with them in the 1990s. Gibson Greetings v. Bankers Trust Co., CV No. C-1-94-620 (S.D. Ohio, filed September 12, 1994) involved a claim for $32 million in compensatory damages and Proctor & Gamble v. Bankers Trust Co., CV No. C-1-94 735 (S.D. Ohio, filed October 27, 1994) involved a claim for $195 million. Gibson was settled for approximately $14 million [some report $6 million] in 1994. The real blockbuster was Orange County Investment Pool v. Merrill Lynch & Co., Ch. 9 Case No. SA 94-22272-JR, Adv. No. SA 94-1045-JR (C.D.B.R. Cal., filed January 12, 1995) in which Orange County sued for $3 billion in damages.

  Although there is great variety in the derivative transactions behind the different litigations, many of the transactions were swaps reflecting bets that interest rates would stay constant during 1993 and 1994. The P&G and Gibson derivatives were complex interest rate swaps where either a rise in short term or long term rates would very quickly put the parties in the red. Orange County involved structured notes called inverse floaters which represented a direct bet that interest rates would stay constant or decline.

  The complaints in these various litigations are based on a combination of common law and statutory claims that can be broken down into four main categories: ultra vires, fraud, suitability and contract. This article examines each theory, as well as the exposure of dealers to regulatory sanctions.

  1.Ultra Vires.

  The basic ultra vires claim is that the customer corporation was prohibited by law from engaging in a particular transaction. For example, Orange County claims that the transactions it entered into with Merrill Lynch were prohibited by the California Constitution because they required Orange County to become indebted in excess of Orange County's income and revenue for the year. Similarly, in Lehman Bros. Commercial Corp. v. China International United Petroleum and Chemicals Co., Ltd. ("UNIPEC"), No. 94-CLV-8304 (S.D.N.Y., filed November 15, 1994), UNIPEC claims that its foreign exchange swaps were in violation of Chinese laws prohibiting all persons, except those approved by the State Administration of Exchange Control, from engaging in foreign exchange transactions.

  The possibility of ultra vires swap contracts was a risk well known since the English case of Hazell v. Hammersmith [1992] 2 AC I where the House of Lords decided that thousands of interest rate swaps entered into by local authorities with banks were ultra vires and therefore void. The resulting mark-to-market losses to the banks have been estimated to be in excess of ~500 million.

  In U.S. corporate law, the ultra vires defense to contract liability has limited application. Corporate charters are now written in very broad terms and, where they are more limited, courts will allow apparent or inherent authority to trump the lack of actual authority. Courts are particularly reluctant to apply the doctrine when it is only invoked to avoid the losing side of a contractual bet and would not have been invoked if the bet had been profitable. As a matter of economic analysis, these limitations on the doctrine make sense. Generally, it would be cheaper for corporate owners to monitor their agents' compliance with a corporate charter than it would be for third parties contracting with the corporation.

  If the Orange County contracts were subjected to this analysis, it might be quite difficult to hold the swap contracts ultra vires. The Treasurer of Orange County quite likely had apparent authority to enter into the contracts even if he did not have actual authority. And clearly the County is seeking to avoid unprofitable contracts which it might well have profited on. Economically, it would seem a lot cheaper for the state or the county to monitor contractual compliance with the state constitution than it would be for the derivative dealer, particularly where the capacity issue involves novel or difficult issues of interpretation of the enabling statutes or constitution. The problem is not simply solved by obtaining a covenant of capacity from a counterparty. Such covenant would not likely be binding absent capacity.

  Of course, Orange County is not a private corporation. One could well argue that the validity of the ultra vires defense should be different in the public contracts area because it is seeking to protect the public fisc for the benefit of taxpayers. On the other hand, why should one private firm rather than the public as a whole bear the loss for imprudent actions of public agents?

  2. Fraud.

  The fraud claims arise either out of common law or statutory law related to securities and commodities, the Securities Act of 1933, the Securities Exchange Act of 1934 (together the "Securities Laws") or the Commodity Exchange Act. As the common law generally imposes no duty to reveal all material information, plaintiffs have a strong incentive to fit the derivative transaction in question into coverage of the Securities Laws or the Commodity Exchange Act. Coverage under these laws hinges on whether certain derivatives are deemed securities or commodities, a matter as yet undecided by the courts.

  However, as a result of the Gibson Greetings case, the CFTC and the SEC both initiated investigations of Bankers Trust that resulted in consent orders whereby Bankers Trust agreed to pay a $10 million fine. See In re BT Securities Corp., Rel Nos. 33-7124, 34-35136, 3-8579, Fed. Sec. L. Rep. (CCH) [1994-1995 Decisions] ~85,477 (December 22, 1994). Both the SEC and CFTC concluded that Bankers Trust had committed fraud in the sale of certain derivatives. In fact, the SEC concluded that two of the twelve types of derivative transactions involving swaps were securities, and the CFTC concluded that all twelve derivatives were some type of commodity option or future contract. Subsequent to the SEC order, P&G amended its complaint to include causes of action based on violations of the Securities Laws. It is still unclear which derivatives are deemed to be securities. The SEC order appears to take the position that swaps which can be characterized as options on securities, or indexes of securities, are securities. Thus, the two derivatives that the SEC deemed to be securities were interest rate swaps whose value was determined in reference to certain T-bill rates. However, the definition of "security" in the '34 Act is extremely broad and might cover all derivatives. As the Supreme Court stated in Reves v. Ernst & Young, 494 U.S. 56, 61 (1990), Congress enacted a definition of "security" that was "sufficiently broad to encompass virtually any instrument that might be sold as an investment."

  Assuming that a derivative is considered a security, the dealer in such a security would have an obligation to disclose material information about the security to a buyer. A major difficulty is encountered in determining what is material information with respect to a particular derivative. This issue has been addressed in a number of forums.


  [There is a discussion of various disclosure standards already covered above.] One effort has touched on disclosure from the dealer -investor perspective. Representatives from various dealer groups, including the International Swaps and Derivatives Association, on August 17, 1995 issued "Principles and Practices for Wholesale Financial Market Transactions.- The preparation of the Principles was coordinated by the Federal Reserve Bank of New York. The Principles do not mandate any disclosure. Section 4.2.2 entitled "Reliance on Investment Advice" provides that a "Participant may communicate to its counterparty economic or market information relating to Transactions and trade or hedging ideas or suggestions. All such communications (whether written or oral) should be accurate and not intentionally misleading." (emphasis added). Section 4.2.3 entitled "Transaction Information" puts the onus on the investor in obtaining information. It provides that:

  A Participant should either ask questions and request additional information or seek independent professional advice when it does not have a full understanding of either the risks involved in a Transaction or the fit between a Transaction and its desired risk profile. A counterparty should answer such questions and respond to such requests for additional information in good faith, and the information provided should be accurate and not intentionally misleading. A participant should expect that, if it does not expressly ask questions or request additional information with respect to a transaction, its counterparty will assume that the Participant understands the transaction and has all the information it needs for its decision-making process.

  The Principles seem to adopt a common law fraud approach under which disclosure is voluntary and only actionable when inaccurate or intentionally misleading, as contrasted with the Securities law approach in which disclosure is mandatory, and the failure to disclose material information is actionable. Also, there is some difficulty in making an investor responsible for not asking the right question. How does one know what he doesn't know?


  OTC derivatives are different from most other securities (including exchange-traded derivatives like futures and options) in one important respect--they are generally offered to and often designed for a particular customer, not the general investing public. This has at least one important consequences. Disclosure needs can be judged in the context of particular investors. Disclosure needed by the Treasurer of P&G could well be different than that needed by less sophisticated investors. Where securities are generally offered to a wide range of investors it is not feasible to tailor disclosure requirements to particular investors, whereas it is feasible for OTC derivatives. In effect, the disclosure issue tends to merge with the suitability issue discussed below.

  3. Suitability.

  Suitability claims appear in two forms: the pure suitability claim and the disclosure suitability claim. In the pure suitability claim the plaintiff claims that the defendant violated his duty to recommend and sell only suitable investments. In order to recover, the plaintiff must prove that the investments were unsuitable, the defendant had a duty not to recommend or sell unsuitable investments, the defendant acted with some level of intent, and that the plaintiff reasonably relied on the defendant's recommendation in purchasing the security. Plaintiffs have pointed to four different sources of rules that can create the duty to recommend or sell only suitable investments: the common law of fiduciary duty, Rule 10b-5 of the '34 Act, the New York Stock Exchange's (NYSE) Know Your Customer Rule, and the National Association of Securities Dealers' (NASD) Suitability Rule.

  In P&G and Gibson Greetings plaintiffs have tried to show that the derivative dealers assumed the role of advisor to the plaintiff and thus assumed fiduciary duties. Other plaintiffs have supplemented the argument with appeal to the NYSE's Know Your Customer Rule and the NASD Suitability Rule. It is currently unclear whether a private right of action exists under these two rules, but it appears that violations of the rules can at least be a factor in determining whether dealers have committed fraud under Rule 10b-5 by selling unsuitable investments. Dealers may have a defense that the plaintiff either knew, or by reasonable investigation could have known, that the investments were unsuitable.

  The central issue in this area is whether a large sophisticated investor should have a suitability claim. While this may seem dubious, the City of San Jose effectively utilized a 10b-5 suitability claim to win a jury verdict against multiple brokerage firms.

  A plaintiff's sophistication alone is generally not dispositive of whether a given investment is suitable. An investment bet with a 100-1 payoff would not appear suitable for a sophisticated retiree with limited resources. Courts rather determine suitability based on the investment objectives of the plaintiff. If a defendant recommends a speculative investment to an investor that he knows is pursuing conservative investment goals, one might conclude it was done with fraudulent intent. However, one might argue that sophistication is quite relevant in this context. If the sophisticated retiree accepts the risky bet, perhaps he has changed his investment objectives.

  Sophistication is clearly relevant to the issue of reasonable reliance. If the plaintiff knew or could have known that the investment was unsuitable to his investment objectives, there is a strong argument that he should not be allowed to recover.

  The disclosure suitability claim is a mixture of a pure suitability claim and a fraud claim. The complaint is that the dealer committed fraud not by recommending or selling an unsuitable security, but by doing so without disclosing that the investment was unsuitable. The sophisticated investor is likely to argue that he reasonably relied on the recommendation given what he was told, but would not have done so if he knew all the facts. The disclosure suitability claim could properly be applied to a sophisticated investor since even a sophisticated investor would be unable to judge the suitability of an investment to his risk preferences without knowing the material risks of the investment.

  The Principles also deal with the suitability issue. Section 4.2.2. Provides:

Absent a written agreement or an applicable law, rule or regulation that expressly imposes affirmative obligations to the contrary, a counterparty receiving ... Communications should assume that the Participant is acting at arm's length for its own account and that such communications are not recommendations or investment advise on which the counterparty may rely.

  Only if an investor informs a dealer that it wishes to rely on its advice, the dealer agrees to do business on that basis and the investor gives the dealer information about his financial situation, will the dealer incur any responsibility for recommending suitable investments.

  The drafters explicitly rejected an "alternative approach" that would require a dealer to determine the suitability of an investment recommendation. Their commentary states, "the alternative approach would undermine the finality of agreed Transactions, and create tremendous uncertainty regarding the economic risk position of participants." Principles, at 7.

  In March 1995 six major securities firms, in cooperation with the SEC and CFTC, agreed to adopt a Framework for Voluntary Oversight ("Voluntary Framework") under which the firms would undertake to have certain management controls, submit quantitative reports covering credit risk exposures, evaluate risk relative to capital and adopt guidelines for dealing with non-professional counterparties to derivatives contracts. While the Voluntary Framework, like the Principles, generally takes an arm's length approach, it goes significantly further in placing affirmative obligations on dealers. In "Counterparty Relationships," II.C (Nature of Relations), it states:

  In cases where existing transaction documentation does not expressly address the nature of the relationship between the professional intermediary and its nonprofessional counterparty and the professional intermediary becomes aware that the nonprofessional counterparty believes incorrectly that the professional intermediary has assumed advisory or similar responsibilities towards the nonprofessional counterparty with respect to a prospective OTC derivative transaction, the professional intermediary should take steps to clarify the nature of the relationship.

  It goes on to provide in II.E:

  Specific Transaction Proposals. In circumstances where a professional intermediary, at the express request of a nonprofessional counterparty, formulates a specific OTC derivative transaction proposal that is tailored to particular transactional objectives specified by the counterparty, the professional intermediary should formulate the transaction proposal in good faith based on the information and objectives specified by the counterparty and subject to the terms of the parties' contractual arrangement.

  And II. F further provides:

  Special Situations. In circumstances where a nonprofessional counterparty has expressly requested assistance in evaluating an OTC derivative transaction in which the payment formula is particularly complex or which includes a significant leverage component, the professional intermediary should offer to provide additional information, such as scenario, sensitivity or other analyses, to the nonprofessional counterparty or should recommend that the counterparty obtain professional advice.

  The Voluntary Framework clearly imposes more obligations on dealers than does the Principles. This partially reflects the different orientation of the regulators involved. The first concern of the SEC in the Voluntary Framework would be to protect investors whereas the first concern of the Federal Reserve Bank of New York in the Principles would be to protect the safety and soundness of banks by limiting their liability. One significant difficulty in this area arises from the proliferation of suitability rules. While none of the private rules are binding, they could well be invoked or cited by courts.

  4. Contract.

  There are two main types of contract claims. The first is that an investor is not bound by his investment agreement. For example, UNIPEC argues that it was not bound by its agreement because it was made by an agent with no authority to bind the corporation, and Gibson argued that a swap with Bankers Trust was not binding because it was made under economic duress in a situation of financial emergency. UNIPEC's argument is a first cousin to the ultra vires argument examined earlier. While UNIPEC does not claim the corporation had no power to enter into the contract, it does claim that the particular agent who entered into the contract had no corporate authority. While it remains to be seen whether the agent had apparent authority even if he lacked actual authority, obviously the claim that an agent acted beyond his authority is a standard one and should not be surprising in the derivatives context.

  The second type of claim is that the contract should embody certain prior oral understandings reached between the parties or, if it does not, that there was no meeting of the minds and thus no contract at all. P&G claims that it never agreed to the secret and proprietary Bankers Trust early lock-in pricing model as a term of its derivative transactions. UNIPEC claims that it had an oral agreement with Lehman Brothers to close out all transactions if they reached a net debt position of $5 million (later raised to 8 million). Again, this is just a standard contract claim. Obviously if derivatives dealers breach their contracts they may be held liable. The implications of this claim are that the key characteristics of the instruments may have to be documented and agreed in writing.

  5. Regulatory Actions.

  The SEC and CFTC actions show that derivatives dealers are exposed to federal agency actions, based on the concerns of these agencies with investor protection. Bank dealers are also exposed to actions by bank regulators. A written Agreement between the Federal Reserve Bank of New York and Bankers Trust of December 5, 1994, Fed. Banking L. Rep. (CCH) [Current] Chapter 90, 332, focuses on Bankers Trust's leveraged derivatives (LDT) business. The Fed's concern is that bank holding companies under its supervision will be damaged by allegations and recoveries based on claims of fraud. Therefore, the remedial measures required by the Agreement require greater disclosure of risks to customers, greater transparency of pricing and better control over the actions of people involved in marketing and selling derivatives.

  For example, the Fed's order requires that BT shall conduct its LDT Business in a manner which seeks to reasonably ensure that each LDT customer has the capability to understand the nature and material terms, conditions, and risks of any LDT entered into with the customer. It further provides that BT shall distribute to each customer written term sheets and sensitivity analyses designed to illustrate a broad range of outcomes and distribution of risks at maturity. BT must constantly update its customers as to risks. The Agreement also provides that BT will update its customer as to the value of positions entered into. It is unclear to what extent the practices set forth in the Agreement will be applied to the derivatives business of other banks.

  6. Conclusion.

  Derivatives dealers face serious threats of liability to sophisticated investors under the various theories of liability examined herein. From the normal perspective of the securities laws, this might appear routine; dealers are just being held accountable for how they sell new investment products, and securities laws have always been applied to sophisticated investors (albeit somewhat differently than to unsophisticated investors). And there is nothing much new about the doctrine of ultra vires or holding parties to contractual obligations. But since many securities dealers are banks, and since significant legal exposures could affect their safety and soundness, there may be a concern about applying normal rules in this situation. The solution to this problem, in my opinion, is not to change the standards, but to make them clearer. Currently, there is much confusion as to what needs to be disclosed with respect to particular derivatives, and what the proper suitability standards should be. Hopefully, these issues will soon be addressed by the SEC.

  There is a significant need to improve the documentation of derivatives transactions; they cannot be documented like standard securities trades. The documents cover such matters as:

  --The relationship of the parties, e.g. is the dealer acting as an advisor or merely a seller.

  --The investment objectives of the customer and the suitability of the derivative given such objectives.

  --The material properties of the derivative (this could be tailored for individual products against a standard baseline for "plain vanilla" products).

  -- Any ongoing reporting duties of the dealer with regard to the value or properties of the product.

(To Be Continued with P&G Litigation and The Dharmala Litigation)