THE PROCTER & GAMBLE COMPANY, Plaintiff, -vs- BANKERS TRUST
COMPANY and BT SECURITIES CORPORATION, Defendants.
No. C-1-94-735
UNITED STATES DISTRICT COURT FOR THE SOUTHERN DISTRICT OF
OHIO, WESTERN DIVISION
925 F. Supp. 1270; 1996 U.S. Dist. LEXIS 6435; Comm. Fut. L.
Rep. (CCH) P26,700; Fed. Sec. L. Rep. (CCH) P99,229
May 8, 1996, Decided
DISPOSITION: [**1] Dismissal under Fed.R.Civ.P. 12(b)6 as to Counts VII -
XV, and summary judgment as to Counts III, IV, and V granted.
COUNSEL: For PROCTOR & GAMBLE, plaintiff: John David Luken, Dinsmore & Shohl -
1, Cincinnati, OH. Thomas Stewart Calder, Dinsmore & Shohl - 1, Cincinnati, OH.
Stanley Morris Chesley, Waite, Schneider, Bayless & Chesley - 1, Cincinnati, OH.
For BANKERS TRUST CO, defendant: Glenn Virgil Whitaker, Daniel Jerome Buckley,
Vorys, Sater, Seymore & Pease - 1, Cincinnati, OH.
For MCGRAW-HILL COMPANIES, INC, movant: Richard Michael Goehler, Frost & Jacobs
- 1, Cincinnati, OH.
For BANKERS TRUST CO, counter-claimant: Glenn Virgil Whitaker, Daniel Jerome
Buckley, Vorys, Sater, Seymour & Pease - 1, Cincinnati, OH.
For PROCTOR & GAMBLE, counter-defendant: John David Luken, Dinsmore & Shohl - 1,
Cincinnati, OH. Thomas Stewart Calder, Dinsmore & Shohl - 1, Cincinnati, OH.
Stanley Morris Chesley, Waite, Schneider, Bayless & Chesley - 1, Cincinnati, OH.
JUDGES: John Feikens, United States District Judge
OPINIONb BY: John Feikens
OPINION: [*1273] OPINION AND ORDER (1) DISMISSING SECURITIES, COMMODITIES
AND OHIO DECEPTIVE TRADE PRACTICES CLAIMS; (2) GRANTING SUMMARY JUDGMENT ON
BREACH OF FIDUCIARY [**2] DUTY, NEGLIGENT MISREPRESENTATION AND NEGLIGENCE
CLAIMS; AND (3) SETTING FORTH DUTIES AND OBLIGATIONS OF THE PARTIES
I. Introduction
Plaintiff, The Procter & Gamble Company ("P&G"), is a publicly traded Ohio
corporation. [*1274] Defendant, Bankers Trust Company ("BT"), is a
wholly-owned subsidiary of Bankers Trust New York Corporation ("BTNY"). BTNY is
a state-chartered banking company. BT trades currencies, securities, commodities
and derivatives. Defendant BT Securities, also a wholly-owned subsidiary of
BTNY, is a registered broker-dealer. The defendants are referred to collectively
as "BT" in this opinion.
P&G filed its Complaint for Declaratory Relief and Damages on October 27,
1994, alleging fraud, misrepresentation, breach of fiduciary duty, negligentmisrepresentation, and negligence in connection with an interest rate swap
transaction it had entered with BT on November 4, 1993. This swap, explained
more fully below, was a leveraged derivatives transaction whose value was based
on the yield of five-year Treasury notes and the price of thirty-year Treasury
bonds ("the 5s/30s swap").
On February 6, 1995, P&G filed its First Amended Complaint for Declaratory
Relief and [**3] Damages, adding claims related to a second swap, entered
into between P&G and BT on February 14, 1994. This second swap was also a
leveraged derivatives transaction. Its value was based on the four-year German
Deutschemark rate. In its First Amended Complaint, P&G also added Counts
alleging violations of the federal Securities Acts of 1933 and 1934, the
Commodity Exchange Act, the Ohio Blue Sky Laws and the Ohio Deceptive Trade
Practices Act. I permitted P&G to file a Second Amended Complaint, which it did
on September 1, 1995.
BT now moves, under Federal Rule of Civil Procedure ("Fed.R.Civ.P.")
12(b)(6), to dismiss the following nine Counts of P&G's Second Amended
Complaint:
Count VII Fraudulent Sale of a Security Under Section 17 of the
Securities Act of 1933
Count VIII Violation of Section 10(b) of the Exchange Act of 1934
and Rule 10b-5
Count IX Fraud in the Sale of Security in Violation of Section
1707.41 of the Ohio Revised Code
Count X Violations of Section 1707.42 of the Ohio Revised Code
Count XI Violations of Section 1707.44 of the Ohio Revised Code
Count XII Willful Deception, Fraud and Cheating in Violation of the
Commodity Exchange Act, @ 4b
Count XIII Scheme or Artifice to Defraud in Violation of the
Commodity Exchange Act, @ 4o
Count XIV Deception, Cheating and Violation of Section 32.9 of the
Rules of the Commodity Futures Trading Commission, 17
C.F.R. @ 32.9
Count XV Ohio Deceptive Trade Practices
[**4]
This motion involves questions of first impression whether the swap
agreements fall within federal securities or commodities laws or Ohio Blue Sky
laws. These are questions of law, not questions of fact. "The judiciary is the
final authority on issues of statutory construction ...." Chevron U.S.A., Inc.
v. Natural Resources Defense Council, Inc., 467 U.S. 837, 843 n.9, 81 L. Ed. 2d
694, 104 S. Ct. 2778 (1984). Mr. Justice Powell stated, in determining
Congressional intent, "the task has fallen to the Securities and Exchange
Commission (SEC), the body charged with administering the Securities Acts, and
ultimately to the federal courts to decide which of the myriad financial
transactions in our society come within the coverage of these statutes." United
Housing Foundation, Inc. v. Forman, 421 U.S. 837, 848, 44 L. Ed. 2d 621, 95 S.
Ct. 2051 (1975).
I conclude that the 5s/30s and DM swap agreements are not securities as
defined by the Securities Acts of 1933 and 1934 and the Ohio Blue Sky Laws; that
these swap agreements are exempt from the Commodity Exchange Act; that there is
no private right of action available to P&G under the antifraud provisions ofthat Act; and that the [**5] choice of law provision in the parties'
agreement precludes claims under the Ohio Deceptive Trade Practices Act.
Therefore, P&G's claims in Counts VII through XV of its Second Amended Complaint
are dismissed.
BT also moves for summary judgment on Counts III - V (Negligent
Misrepresentation, Breach of Fiduciary Duty, and Negligence). I conclude that as
a counterparty to swap [*1275] agreements, BT owed no fiduciary duty to P&G.
P&G's claims of negligent misrepresentation and negligence are redundant, as I
have set forth the duties and obligations of the parties under New York law.
Therefore, summary judgment is granted as to Counts III - V.
II. Background
Financial engineering, in the last decade, began to take on new forms. A
current dominant form is a structure known as a derivatives transaction. It is
"a bilateral contract or payments exchange agreement whose value derives ...
from the value of an underlying asset or underlying reference rate or index."
Global Derivatives Study Group of the Group of Thirty, Derivatives: Practices
and Principles 28 (1993). Derivatives transactions may be based on the value of
foreign currency, U.S. Treasury bonds, stock indexes, or interest [**6]
rates. The values of these underlying financial instruments are determined by
market forces, such as movements in interest rates. Within the broad panoply of
derivatives transactions are numerous innovative financial instruments whose
objectives may include a hedge against market risks, management of assets and
liabilities, or lowering of funding costs; derivatives may also be used as
speculation for profit. Singher, Regulating Derivatives: Does Transnational
Regulatory Cooperation Offer a Viable Alternative to Congressional Action? 18
Fordham Int'l. Law J. 1405-06 (1995).
This case involves two interest rate swap agreements. A swap is an agreement
between two parties ("counterparties") to exchange cash flows over a period of
time. Generally, the purpose of an interest rate swap is to protect a party from
interest rate fluctuations. The simplest form of swap, a "plain vanilla"
interest-rate swap, involves one counterparty paying a fixed rate of interest,
while the other counterparty assumes a floating interest rate based on the
amount of the principal of the underlying debt. This is called the "notional"
amount of the swap, and this amount does not change hands; only the interest
[**7] payments are exchanged.
In more complex interest rate swaps, such as those involved in this case, the
floating rate may derive its value from any number of different securities,
rates or indexes. In each instance, however, the counterparty with the floating
rate obligation enters into a transaction whose precise value is unknown and is
based upon activities in the market over which the counterparty has no control.
How the swap plays out depends on how market factors change.
One leading commentator describes two "visions" of the "explosive growth of
the derivatives market." Hu, Hedging Expectations: "Derivative Reality" and the
Law and Finance of the Corporate Objective, Vol. 73 Texas L. Rev. 985 (1995).
One vision, that relied upon by derivatives dealers, is that of perfect hedges
found in formal gardens. This vision portrays
the order -- the respite from an otherwise chaotic universe -- made possible by financial science. Corporations are subject to volatile financial and
commodities markets. Derivatives, by offering hedges against almost any kind of
price risk, allow corporations to operate in a more ordered world.
Id. at 994.
The other vision is that of [**8] "science run amok, a financial Jurassic
Park." Id. at 989. Using this metaphor, Hu states:
In the face of relentless competition and capital market disintermediation,
banks in search of profits have hired financial scientists to develop new
financial products. Often operating in an international wholesale market open
only to major corporate and sovereign entities -- a loosely regulated paradise
hidden from public view -- these scientists push the frontier, relying on
powerful computers and an array of esoteric models laden with incomprehensible
Greek letters. But danger lurks. As financial creatures are invented,
introduced, and then evolve and mutate, exotic risks and uncertainties arise. In
its most fevered imagining, not only do the trillions of mutant creatures
destroy their creators in the wholesale market, but they escape and [*1276]
wreak havoc in the retail market and in economies worldwide.
Id. at 989-90.
Given the potential for a "financial Jurassic Park," the size of the
derivatives market n1 and the complexity of these financial instruments, it is
not surprising that there is a demand for regulation and legislation. Several
bills have been introduced in [**9] Congress to regulate derivatives. n2 BT
Securities has been investigated by the Securities and Exchange Commission
("SEC") and by the Commodities Futures Trading Commission ("CFTC") regarding a
swap transaction with a party other than P&G. In re BT Securities Corp., Release
Nos. 33-7124, 34-35136 and CFTC Docket No. 95-3 (Dec. 22, 1994). Bankers Trust
has agreed with the Federal Reserve Bank to a Consent Decree on its leveraged
derivatives transactions.
- - - - - - - - - - - - - - - - - -Footnotes- - - - - - - - - - - - - - - - - -
n1 Estimates of the amount of usage of derivatives range from $ 14 trillion
to $ 35 trillion in face or notional amounts. Cohen, The Challenge of
Derivatives, Vol. 63 Fordham L. Rev. 1993 (1995).
n2 See H.R. 31, 104th Cong. 1st Sess. (1995); H.R. 20, 104th Cong. 1st Sess.
(1995); H.R. 4745, 103rd Cong. 2d. Sess. (1994).
- - - - - - - - - - - - - - - - -End Footnotes- - - - - - - - - - - - - - - - -
At present, most derivatives transactions fall in "the common-law no-man's
land beyond regulations -- ... interest-rate and equity swaps, swaps with
embedded options ('swaptions')," and other equally creative financial
instruments. [**10] Cohen, The Challenge of Derivatives, Vol. 63 Fordham L.
Rev. at 2013. This is where the two highly specialized swap transactions
involved in this case fall.
III. The P&G/BT Swap Agreements Those swaps transactions are governed by written documents executed by BT and
P&G. BT and P&G entered into an Interest Rate and Currency Exchange Agreement on
January 20, 1993. This standardized form, drafted by the International Swap
Dealers Association, Inc. ("ISDA"), together with a customized Schedule and
written Confirmations for each swap, create the rights and duties of parties to
derivative transactions. By their terms, the ISDA Master Agreement, the
Schedule, and all Confirmations form a single agreement between the parties.
During the fall of 1993, the parties began discussing the terms of an
interest rate swap which was to be customized for P&G. After negotiations, the
parties agreed to a swap transaction on November 2, 1993, which is referred to
as the 5s/30s swap; the written Confirmation is dated November 4, 1993.
In the 5s/30s swap transaction, BT agreed to pay P&G a fixed rate of interest
of 5.30% for five years on a notional amount of $ 200 million. P&G agreed to
[**11] pay BT a floating interest rate. For the first six months, that
floating rate was the prevailing commercial paper ("CP") interest rate minus 75
basis points (0.75%). For the remaining four-and-a-half years, P&G was to make
floating interest rate payments of CP minus 75 basis points plus a spread. The
spread was to be calculated at the end of the first six months (on May 4, 1994)
using the following formula:
Spread = (98.5 * [5 year CMT] - 30 T Price)
5.78%
100
In this formula, the "5 year CMT" (Constant Maturity Treasury) represents the
yield on the five-year Treasury Note, and the "30 T Price" represents the price
of the thirty-year Treasury Bond. The leverage factor in this formula meant that
even a small movement up or down in prevailing interest rates results in an
incrementally larger change in P&G's position in the swap.
The parties amended this swap transaction in January 1994; they postponed the
date the spread was to be set to May 19, 1994, and P&G was to receive CP minus
88 basis points, rather than 75 basis points, up to the spread date.
In late January 1994, P&G and BT negotiated a second swap, known as the "DM
swap", based on the value [**12] of the German Deutschemark. The Confirmation
for this swap is dated February 14, 1994. For the first year, BT was to pay P&G
a floating interest rate plus 233 basis points. P&G was to pay the same floating
rate plus 133 basis points; P&G thus received a 1% premium for the first year,
the effective [*1277] dates being January 16, 1994 through January 16, 1995.
On January 16, 1995, P&G was to add a spread to its payments to BT if the
four-year DM swap rate ever traded below 4.05% or above 6.01% at any time
between January 16, 1994, and January 16, 1995. If the DM swap rate stayed
within that band of interest rates, the spread was zero. If the DM swap rate
broke that band, the spread would be set on January 16, 1995, using the
following formula:
Spread = 10 * [4-year DM swap rate - 4.50%]
The leverage factor in this swap was shown in the formula as ten.
P&G unwound both of these swaps before their spread set dates, as interest
rates in both the United States and Germany took a significant turn upward, thus
putting P&G in a negative position vis-a-vis its counterparty BT. BT now claims
that it is owed over $ 200 million on the two swaps, while P&G claims the swaps
were fraudulently [**13] induced and fraudulently executed, and seeks a
declaratory verdict that it owes nothing. n3
- - - - - - - - - - - - - - - - - -Footnotes- - - - - - - - - - - - - - - - - -
n3 P&G seeks other relief, i.e., punitive damages, attorney fees, and other
costs.
- - - - - - - - - - - - - - - - -End Footnotes- - - - - - - - - - - - - - - - -
IV. Federal Securities Claims (Counts VII and VIII)
In the 1933 Securities Act, Congress defined the term "security" as
any note, stock, treasury stock, bond, debenture, evidence of indebtedness,
certificate of interest or participation in any profit-sharing agreement,
collateral-trust certificate, preorganization certificate or subscription,
transferrable share, investment contract, voting-trust certificate, certificate
of deposit for a security, fractional undivided interest in oil, gas, or other
mineral rights, any put, call, straddle, option, or privilege on any security,
certificate of deposit, or group or index of securities (including any interest
therein or based on the value thereof), or any put, call, straddle, option, or
privilege entered into on a national securities exchange relating to foreign
currency, [**14] or, in general, any interest or instrument commonly known
as a "security", or a certificate of interest or participation in, temporary or
interim certificate for, receipt for, guarantee of, or warrant or right to
subscribe to or purchase, any of the foregoing.
15 U.S.C. @ 77b(1). The definition section of the 1934 Act, 15 U.S.C. @
78c(a)(10), is virtually identical and encompasses the same instruments as the
1933 Act. Reves v. Ernst & Young, 494 U.S. 56, 61 n.1, 108 L. Ed. 2d 47, 110 S.
Ct. 945 (1989).
P&G asserts that the 5s/30s and DM swaps fall within any of the following
portions of that definition: 1) investment contracts; 2) notes; 3) evidence of
indebtedness; 4) options on securities; and 5) instruments commonly known as
securities.
Congress intended a broad interpretation of the securities laws and
flexibility to effectuate their remedial purpose of avoiding fraud. SEC v.
Howey, 328 U.S. 293, 90 L. Ed. 1244, 66 S. Ct. 1100 (1946). The United States
Supreme Court has held, however, that Congress did not "intend" the Securities
Acts "to provide a broad federal remedy for all fraud." Marine Bank v. Weaver,
455 U.S. 551, 556, 71 L. Ed. 2d 409, 102 S. Ct. 1220 [**15] (1982). The
threshold issue presented by P&G's securities fraud claims is whether a security
exists, i.e., whether or not these swaps are among "the myriad financial
transactions in our society that come within the coverage of these statutes."
Forman, 421 U.S. at 849. Economic reality is the guide for determining whether these swaps
transactions that do not squarely fit within the statutory definition are,
nevertheless, securities. Reves, 494 U.S. at 62. In order to determine if these
swaps are securities, commodities, or neither), I must examine each aspect of
these transactions and subject them to the guidelines set forth in Supreme Court
cases.
A. Investment Contracts
For purposes of the federal securities laws, an "investment contract" is
defined as "a contract, transaction or scheme whereby a person invests his money
in a common enterprise." Howey, 328 U.S. at 298-99. Stated differently, the test
whether an instrument is an investment contract is whether it entails "an
investment in a [*1278] common venture premised on a reasonable expectation
of profits to be derived from the entrepreneurial or managerial efforts of
others." Forman, 421 U.S. at 852. [**16] The U.S. Court of Appeals for the
Sixth Circuit has interpreted the Howey test as a "flexible one 'capable of
adaptation or meeting the countless and variable schemes devised by those who
seek the use of the money of others on the promise of profits.'" Stone v. Kirk,
8 F.3d 1079, 1085 (6th Cir. 1993), quoting Howey, 328 U.S. at 299.
BT argues that the swaps are not investment contracts because 1) neither P&G
nor BT invested any money; rather, they agreed to exchange cash payments at
future dates; 2) the swaps did not involve an investment in a "common
enterprise," which involves the pooling of funds in a single business venture,
Deckebach v. LaVida Charters, Inc. of Fla., 867 F.2d 278, 281 (6th Cir. 1989);
and 3) any gains to be derived from the swaps were not "profits," which are
defined as "capital appreciation" or "participation in earnings" of a business
venture. Forman, 421 U.S. at 852; Union Planters Nat'l Bank of Memphis v.
Commercial Credit Business Loans, Inc., 651 F.2d 1174, 1185 (6th Cir.), cert.
den. 454 U.S. 1124, 71 L. Ed. 2d 111, 102 S. Ct. 972 (1981) (profits must be
derived from the "managerial or entrepreneurial efforts of others"). BT
[**17] contends that cash payments to be made arise not from the efforts of
others, but from changes in U.S. and German interest rates.
P&G counters that the swaps are investments of money because an investment
exists where an investor has committed its assets in such a way that it is
subject to a financial loss and that the commitment to make future payments is
sufficient to constitute an investment; further, that the swaps meet the "common
enterprise" tests because its swaps, when combined with those of other parties,
became part of the capital used to support BT's derivatives business.
Specifically, P&G argues, BT combines its sales in one hedge book to offset all
of its customers' transactions, and unwind prices reflect BT's overall portfolio
risk. P&G further contends that its profit motive was its desire to reduce its
overall interest costs and that it expected to derive profits from the efforts
of BT in structuring and monitoring the swaps.
While the swaps may meet certain elements of the Howey test whether an
instrument is an investment contract, what is missing is the element of a
"common enterprise." P&G did not pool its money with that of any other company
or person in a [**18] single business venture. How BT hedged its swaps is not
what is at issue -- the issue is whether a number of investors joined together
in a common venture. Certainly, any counterparties with whom BT contracted
cannot be lumped together as a "common enterprise." Furthermore, BT was notmanaging P&G's money; BT was a counterparty to the swaps, and the value of the
swaps depended on market forces, not BT's entrepreneurial efforts. The swaps are
not investment contracts.
B. Notes or "Family Resemblance" to Notes
BT asserts that the swaps are not notes because they did not involve the
payment or repayment of principal. P&G responds that the counterparties incurred
payment obligations that were bilateral notes or the functional equivalent of
notes.
As with the test whether an instrument is an investment contract, these swap
agreements bear some, but not all, of the earmarks of notes. At the outset, and
perhaps most basic, the payments required in the swap agreements did not involve
the payment or repayment of principal. See Sanderson v. Roethenmund, 682 F.
Supp. 205, 206 (S.D. N.Y. 1988) (promises to pay a specified sum of principal
and interest to the payee at a specified time [**19] are to be analyzed as
"notes" for the purposes of the Securities Acts).
In Reves, 494 U.S. at 64-67, the Supreme Court set out a four-part "family
resemblance" test for identifying notes that should be deemed securities. Those
factors are: 1) the motivations of the buyer and seller in entering into the
transaction (investment for profit or to raise capital versus commercial); 2) a
sufficiently broad [*1279] plan of distribution of the instrument (common
trading for speculation or investment); 3) the reasonable expectations of the
investing public; and 4) whether some factor, such as the existence of another
regulatory scheme, significantly reduces the risk of the instrument, thereby
rendering application of the securities laws unnecessary.
In explaining the first prong of the "family resemblance" test, the Court in
Reves distinguished between the motivations of the parties in entering into the
transaction, drawing a line between investment notes as securities and
commercial notes as non-securities. The Court said:
If the seller's purpose is to raise money for the general use of a business
enterprise or to finance substantial investments and the buyer is interested
primarily [**20] in the profit the note is expected to generate, the
instrument is likely to be a "security." If the note is exchanged to facilitate
the purchase and sale of a minor asset or consumer good, to correct for the
seller's cash-flow difficulties, or to advance some other commercial or consumer
purpose, on the other hand, the note is less sensibly described as a "security."
Reves, 494 U.S. at 66.
There is no "neat and tidy" way to apply this prong of the test, in part
because P&G and BT were counterparties, not the typical buyer and seller of an
instrument. BT's motive was to generate a fee and commission, while P&G's
expressed motive was, in substantial part, to reduce its funding costs. These
motives are tipped more toward a commercial than investment purpose. As to P&G,
there was also an element of speculation driving its willingness to enter a
transaction that was based on its expectations regarding the path that interest
rates would take. Thus, this prong of the Reves test, standing alone, is not a
sufficient guide to enable one to make the determination whether the 5s/30s and
DM swaps were notes within the meaning of the Securities Acts.
The second prong of the [**21] Reves test examines the plan of
distribution of the instrument "to determine whether it is an instrument in
which there is 'common trading for speculation or investment.'" Id., quoting SEC
v. C.M. Joiner Leasing Corp., 320 U.S. 344, 351, 88 L. Ed. 88, 64 S. Ct. 120
(1943). While derivatives transactions in general are an important part of BT's
business, and BT advertises its expertise in putting together a variety of
derivatives packages, the test is whether the 5s/30s and DM swaps in particular
were widely distributed. These swaps are analogous to the notes that were held
not to be securities on the basis that the plan of distribution was "a limited
solicitation to sophisticated financial or commercial institutions and not to
the general public." Banco Espanol de Credito v. Security Pacific Nat'l Bank,
763 F. Supp. 36, 43 (S.D. N.Y. 1991), aff'd 973 F.2d 51 (2d Cir. 1992). The
5s/30s and DM swaps were customized for Procter & Gamble; they could not be sold
or traded to another counterparty without the agreement of BT. They were not
part of any kind of general offering.
Thus, I conclude that the 5s/30s and DM swaps were not widely distributed and
do not meet the [**22] second prong of the Reves test.
Application of the third Reves factor -- the public's reasonable perceptions
-- does not support a finding that these swap agreements are securities. They
were not traded on a national exchange, "the paradigm of a security." Reves, 494
U.S. at 69. I recognize that some media refer to derivatives generally as
securities and that some commentators assume that all derivatives are
securities. Other commentators understand that many swap transactions are
customized, bilateral contracts not subject to regulation. Cohen, 63 Fordham L.
Rev. at 2013. However, what is relevant is the perception of those few who enter
into swap agreements, not the public in general. P&G knew full well that its
over-the-counter swap agreements with BT were not registered with any regulatory
agency. P&G's "perception" that these swap agreements were securities did not
surface until after it had filed its original Complaint in this case.
Thus, I conclude that the 5s/30s and DM swaps do not meet the third prong of
the Reves test.
The fourth Reves factor is whether another regulatory scheme exists that
would control [*1280] and thus reduce the risk of the instrument, [**23]
making application of the securities laws unnecessary. At about the time these
swaps were entered into, the guidelines of the Office of the Comptroller of
Currency ("OCC") and the Federal Reserve Board went into effect. OCC Banking
Circular 277, Risk Management of Financial Derivatives, Fed. Banking L. Rep.
(CCH) P 62,154, at 71,703 (Oct. 27, 1993); Federal Reserve Board Supervisory
Letter SR 93-69, Examining Risk Management and Internal Controls for Trading
Activities of Banking Organizations, Fed. Banking L. Rep. P 62-152, at 71,712
(Dec. 20, 1993); OCC Bulletin 94-31, Questions and Answers for BC-277: Risk
Management of Financial Derivatives, Fed. Banking L. Rep. P 62-152, at 71, 719
(May 10, 1994).
While these guidelines are useful in regulating the banking industry, their
focus is the protection of banks and their shareholders from default or other
credit risks. They do not provide any direct protection to counterparties with
whom banks enter into derivatives transactions. While the 5s/30s and DM swaps
may meet this prong of the Reves "family resemblance" test, this is not enough
to bring these transactions within the statutory definition of a "note" forpurposes [**24] of the securities laws.
Balancing all the Reves factors, I conclude that the 5s/30s and DM swaps are
not notes for purposes of the Securities Acts.
C. Evidence of Indebtedness
P&G argues that if the swaps are not notes, they are evidence of indebtedness
because they contain bilateral promises to pay money and they evidence debts
between the parties. It argues that the counterparties promised to pay a debt,
which consists of future obligations to pay interest on the notional amounts.
Indeed, BT now claims that it is owed millions of dollars on the swaps. P&G
points out that the phrase "evidence of indebtedness" in the statute must have a
meaning other than that given to a "note" so that the words "evidence of
indebtedness" are not redundant. Thus, it argues, without citation to authority,
that if the swaps are not notes, then they should be construed as an evidence of
indebtedness "either because they may contain terms and conditions well beyond
the typical terms of a note and beyond an ordinary investor's ability to
understand, or because the debt obligation simply does not possess the physical
characteristics of a note."
The test whether an instrument is within the category [**25] of "evidence
of indebtedness" is essentially the same as whether an instrument is a note.
Holloway v. Peat, Marwick, Mitchell & Co., 879 F.2d 772, 777 (10th Cir. 1989),
judgment vacated on other grounds sub nom. Peat Marwick Main Co. v. Holloway,
494 U.S. 1014, 108 L. Ed. 2d 490, 110 S. Ct. 1314 (1990), re aff'd on remand,
900 F.2d 1485 (10th Cir.), cert. den. 498 U.S. 958 (1990) (passbook savings
certificates and thrift certificates were analyzed under the "note" or "evidence
of indebtedness" categories, as they represented a promise to repay the
principal amount, plus accrued interest); In re Tucker Freight Lines, Inc., 789
F. Supp. 884, 885 (W.D. Mich. 1991) (The Court's "method [in Reves] seems
applicable to all debt instruments, including evidences of indebtedness.").
I do not accept P&G's definition of "evidence of indebtedness" in large part
because that definition omits an essential element of debt instruments -- the
payment or repayment of principal. Swap agreements do not involve the payment of
principal; the notional amount never changes hands.
D. Options on Securities
An option is the right to buy or sell, for a limited time, a particular
[**26] good at a specified price.
Five-year notes and thirty-year Treasury bonds are securities; therefore, P&G
contends that the 5s/30s swap is an option on securities. n4 It argues that
because the 5s/30s swap spread was based on the value of these [*1281]
securities, it falls within the statutory definition: "any put, call, straddle,
option or privilege on any security, group or index of securities (including any
interest therein or based on the value thereof)." It describes the 5s/30s swap
as "a single security which can be decomposed into a plain vanilla swap with an
embedded put option. The option is a put on the 30-year bond price with an
uncertain strike price that depends on the level of the 5-year yield at the end
of six months."
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n4 P&G does not contend that the DM swap was an option on a security for
purposes of the 1933 and 1934 Acts. Indeed, the underlying instrumentality of
the DM swap was not a security, because the value of the DM swap was based on a
foreign currency, which is not a security as defined in the 1933 and 1934 Acts.
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[**27]
BT contends that the 5s/30s swap is not an option because no one had the
right to take possession of the underlying securities. BT argues that although
both swaps contained terms that functioned as options, they were not options
because they did not give either party the right to sell or buy anything.
According to BT, the only "option-like" feature was the spread calculation that
each swap contained; that any resemblance the spread calculations had to options
on securities does not extend to the underlying swaps themselves, which had no
option-like characteristics. I agree that the 5s/30s swap was not an option on a
security; there was no right to take possession of any security.
The definition of a "security" in the 1933 and 1934 Acts includes the
parenthetical phrase "(including any interest therein or based on the value
thereof)," which could lead to a reading of the statute to mean that an option
based on the value of a security is a security. Legislative history, however,
makes it clear that that reading was not intended. The U.S. House of
Representatives Report ("House Report") on the 1982 amendments that added this
parenthetical phrase provides that the definition of "security" [**28]
includes an option on "(i) any security, (ii) any certificate of deposit, (iii)
any group or index of securities (including any interest therein or based on the
value thereof), and (iv) when traded on a national securities exchange, foreign
currency." H.R. Rep. No. 626, 97th Cong., 2d Sess., pt. 2, at 4 (1982),
reprinted in 1982 U.S.C.C.A.N. 2780, 2795. Thus, even though the statute jumbles
these definitions together, it is clear from the House Report that the
parenthetical phrase "(... based on the value thereof)" was intended only to
modify the immediately preceding clause -- "group or index of securities" -- and
not the words "any option" or "any security."
Two Orders by the Security and Exchange Commission must be considered. These
rulings involve transactions between BT and Gibson Greetings, Inc. in swaps that
have some similarities to the 5s/30s swap. In re BT Securities Corp., Release
Nos. 33-7124, 34-35136 (Dec. 22, 1994), and In the Matter of Mitchell A.
Vazquez, Release Nos. 33-7269, 34-36909 (Feb. 29, 1996). In these cases, the SEC
ruled that a "Treasury-Linked Swap" between BT and Gibson Greetings, Inc. was a
security within the meaning of the federal securities [**29] laws. The SEC
stated: "While called a swap, the Treasury-Linked Swap was in actuality a
cash-settled put option that was written by Gibson and based initially on the
'spread' between the price of the 7.625% 30-year U.S. Treasury maturity maturing
on November 15, 2022 and the arithmetic average of the bid and offered yields of
the most recently auctioned obligation of a two-year Treasury note."
These SEC Orders were made pursuant to Offers of Settlement made by BT
Securities and Vazquez. In both Orders, the SEC acknowledged that its findings
were solely for the purpose of effectuating the respondents' Offers of
Settlement and that its findings are not binding on any other person or entitynamed as a defendant or respondent in any other proceeding. They are not binding
in this case, in part because of the differences between the transactions; nor
do they have collateral estoppel effect. See also SEC v. Sloan, 436 U.S. 103,
118, 56 L. Ed. 2d 148, 98 S. Ct. 1702 (1978) (citations omitted) (The "courts
are the final authorities on the issues of statutory construction and are not
obliged to stand aside and rubber-stamp their affirmance of administrative
decisions that they deem inconsistent [**30] with a statutory mandate or that
frustrate the congressional policy underlying a statute.").
Even though both the Gibson Greetings, Inc. swap and the P&G 5s/30s swap
derived their values from securities (Treasury notes), they were not options.
While these swaps [*1282] included option-like features, there is a missing
essential element of an option. These swaps were exchanges of interest payments;
they did not give either counterparty the right to exercise an option or to take
possession of any security. Neither party could choose whether or not to
exercise an option; the stream of interest payments under the swap was
mandatory. Consequently, I conclude that the 5s/30s swap is not an option on a
security or an option based on the value of a security.
E. Instruments Commonly Known as Securities
Finally, P&G contends that both the 5s/30s and the DM swaps are securities
simply because that is how these instruments were offered and how they have
become known through a course of dealing. In support of this position, P&G
points to the SEC Orders in the Gibson Greetings matter and asserts that BT
labels leveraged derivatives as investments, speculative, and options; and that
the financial [**31] markets and the media characterize derivatives as
securities.
The Supreme Court uses the Howey test for both "investment contracts" and the
more general category of an "instrument commonly known as a "security." Landreth
Timber Co. v. Landreth, 471 U.S. 681, 691 n. 5, 85 L. Ed. 2d 692, 105 S. Ct.
2297 (1985); Forman, 421 U.S. at 852 ("We perceive no distinction, for present
purposes, between an 'investment contract' and an 'instrument commonly known as
a 'security.'" In either case, the basic test for distinguishing the transaction
from other commercial dealings is 'whether the scheme involves an investment of
money in a common enterprise with profits to come solely from the efforts of
others.'" Howey, 328 U.S. at 301").
Even before the Howey decision, the Supreme Court established a contextual
connection between an "investment contract" and "instrument commonly known as a
'security'" in Joiner Leasing, 320 U.S. at 351, where the Supreme Court stated:
In the Securities Act the term "security" was defined to include by name or
description many documents in which there is common trading for speculation or
investment. Some, such as notes, bonds, and stocks, [**32] are pretty much
standardized and the name alone carries well-settled meaning. Others are of more
variable character and were necessarily designated by more descriptive terms,
such as "transferable share," "investment contract," and "in general any
interest or instrument commonly known as a security." We cannot read out of the
statute these general descriptive designations merely because more specific ones
have been used to reach some kinds of documents. Instruments may be included
within any of these definitions, as matter of law, if on their face they answer
to the name or description. However, the reach of the Act does not stop withthe obvious and commonplace. Novel, uncommon, or irregular devices, whatever
they appear to be, are also reached if it be proved as a matter of fact that
they are widely offered or dealt in under terms or courses of dealing which
established their character in commerce as "investment contracts," or as "any
interest or instrument commonly known as a 'security.'"
While neither Joiner Leasing, nor Landreth, nor Forman dealt with instruments
comparable to the leveraged derivatives involved in this case, the reasoning of
the Supreme Court is [**33] applicable. In each of these cases, the Court
emphasized that when a party seeks to fit financial instruments into the
non-specific categories of securities, those instruments must nevertheless
comport with the Howey test, which "embodies the essential attributes that run
through all of the Court's decisions defining a security. The touchstone is the
presence of an investment in a common venture premised on a reasonable
expectation of profits to be derived from the entrepreneurial or managerial
efforts of others." Forman, 421 U.S. at 852.
In determining whether the 5s/30s and DM swaps are instruments commonly known
as securities, P&G's own pleadings are telling in defining how P&G viewed these
transactions. In recent motions, P&G asserts that it knew of the alleged fraud
in the 5s/30s swap in mid-April 1994. Yet, P&G did not [*1283] bring
securities claims when it filed its original Complaint in October 1994. P&G did
not assert a claim for securities violations until January 1995, after the SEC
and CFTC issued their rulings in the Gibson Greetings matter. If P&G itself had
really thought it was dealing with securities, it is fair to assume that P&G
would have included securities counts [**34] in its original Complaint.
In any event, the contracts between P&G and BT do not meet the Howey
criteria, particularly because there is no way that they can be construed to be
a pooling of funds in a common enterprise. These swap's do not qualify as
securities.
It is important to point out that the holdings in this case are narrow; I do
not determine that all leveraged derivatives transactions are not securities, or
that all swaps are not securities. Some of these derivative instruments, because
of their structure, may be securities. I confine my ruling to the 5s/30s and the
DM swaps between P&G and BT.
V. Ohio Securities Laws Claims (Counts IX - XI)
Ohio's Blue Sky law, Ohio Rev. Code @ 1707.01 (B) (1992) defines "security"
in pertinent part as follows:
any certificate or instrument that represents title to or interest in ... the
capital, assets, profits, property, or credit of any person or of any public or
governmental body, subdivision, or agency. It includes ... warrants or options
to purchase securities, promissory notes, all forms of commercial paper,
evidences of indebtedness, ... any investment contract, any instrument
evidencing a promise or an [**35] agreement to pay money, ... and the
currency of any government other than those of the United States or Canada, ...
Ohio's test for an investment contract is somewhat broader than the Howey
test set out by the United States Supreme Court. State v. George, 50 Ohio App.
2d 297, 362 N.E.2d 1223, 1227 (Ohio App. 1975). Under Ohio law, an investmentcontract is created whenever:
(1) An offeree furnishes initial value to an offeror,
(2) A portion of the initial value is subjected to the risks of the enterprise,
(3) The furnishing of the initial value is induced by the offeror's promises or
representations which give rise to a reasonable understanding that a valuable
benefit of some kind, over and above the initial value, will accrue to the
offeree as a result of the operation of the enterprise, and
(4) The offeree does not receive the right to exercise practical and actual
control over managerial decisions of the enterprise.
Deckebach, 867 F.2d at 284 (construing Ohio law), citing George, 362 N.E.2d at
1227. Even though this test may be broader than the Howey test, Ohio law still
requires a finding of common enterprise. The Ohio Supreme Court stated:
[**36]
The question ... is whether it appears that the contributed sums would
reasonably find their way into the general operations of the enterprise. Stated
another way, it is whether such investment will become a part of the capital
pool used to conduct the business being promoted by the offeror. If so, such
initial value furnished by the offeree may be considered as risk capital of the
enterprise.
George, 362 N.E.2d at 1228.
P&G continues to argue that the "enterprise" in its swap transactions was
BT's general derivatives operations and the hedging connected with that part of
its business. This argument misses the point -- the funds invested must be used
in the venture being promoted. Id. P&G was not investing in BT's business, nor
was BT offering P&G profits from its derivatives business. How BT hedged its
swaps, whether individually or on a portfolio basis is immaterial to whether P&G
would profit or lose in its swaps. P&G knew that the performance of the swaps
was wholly dependent on the value of Treasury notes and bonds and the German
Deutschemark. P&G's fate on its swaps was not dependent on how well or how
poorly BT hedged those swaps. Thus, P&G's swaps were [**37] not part of BT's
enterprise. Because that element is missing in the 5s/30s and DM swaps, they are
not securities under [*1284] the "investment contract" provision of the Ohio
Blue Sky laws.
The Ohio statute contains a provision that the federal law does not have --
"any instrument evidencing a promise or an agreement to pay money." P&G argues
that the Sixth Circuit decision in Riedel v. Bancam, S.A., 792 F.2d 587 (6th
Cir. 1986), applies to this issue. In that case, Judge Kennedy held that
certificates of deposit issued by a Mexican bank were not securities under the
federal securities laws, but would fall within the definition of "security"
under the "broadly drafted" Ohio law covering "evidences of indebtedness" and
"any instrument evidencing a promise or an agreement to pay money." Id. at
593-594.
While reinforcing the premise that Ohio's securities laws are broadly
written, the Riedel case is not binding here. Swaps are not certificates of
deposit; they are bilateral promises to pay in the future, the amount of which
would depend on the rise or fall of the market. Such promises to pay are not
securities under Ohio law. See Emery v. So-Soft of Ohio, Inc., 30 Ohio Op. 2d226, [**38] 199 N.E.2d 120, 125 (Ohio App. 1964) (agreement to pay fee for
each referral of customer that resulted in the sale of a water conditioner was
not a security; "the agreement contained a promise to pay money, but so do most
salesmen's commission and employment contracts." This unilateral contract was
merely an offer to pay for the performance of certain acts).
If one were to interpret the phrase "instruments evidencing a promise or an
agreement to pay money" as broadly as P&G asks, this classification would mean
that every private agreement to pay money, including such things as charge slips
that customers sign for credit card purchases, would fall within the securities
laws. This is not the legislative intent. Rather, one must look to the broader
perspective and the requirement of the first sentence of @ 1701.01(B) that the
security instrument must represent an interest in the capital, assets, profits,
property or credit of the party issuing the instrument. Interest rate swaps do
not embody any of these indices of a security.
Finally, P&G contends that the DM swap is a security because the Ohio
definition of security includes "the currency of any government other than those
[**39] of the United States and Canada." P&G cites no authority for the
proposition that the DM swap, whose value was tied to the four-year German swap
rate, was the equivalent of German currency. The DM swap entitled no one to any
amount of German currency; the DM transaction was an interest rate swap, not a
currency swap, and thus does not come within this aspect of the Ohio definition
of a security.
Therefore, Counts IX, X, and XI are dismissed; the swaps are not within the
definition of a "security" in Ohio law, and the parties' agreement precludes
application of Ohio law (see Section VII below).
VI. Commodities (Counts XII - XIV)
The Commodity Exchange Act ("CEA") includes in its definition of a commodity
"all services, rights, and interests in which contracts for future delivery are
presently or in the future dealt in." 7 U.S.C. @ 1a(3). BT asserts that the
swaps are not futures contracts; P&G claims that they are.
Under the CEA, The Commodity Futures Trading Commission has exclusive
jurisdiction over "accounts, agreements ... and transactions involving contracts
of sale of a commodity for future delivery traded or executed on a contract
market ... or any other board [**40] of trade, exchange, or market, and
transactions [in standardized contracts for certain commodities]." As of January
19, 1996, the CFTC had "not taken a position on whether swap agreements are
futures contracts." Letter from Mary L. Schapiro, Chair of U.S. Commodity
Futures Trading Commission to Congressmen Roberts and Bliley, p.4 (Jan. 19,
1996). This opinion does not decide that issue because the 5s/30s and DM swaps
are within the Swaps Exemption to the CEA and because P&G has not stated a claim
under @ 4b, @ 4o, or 17 C.F.R. @ 32.9, as discussed below.
A. Swaps Exemption
Even if the 5s/30s and DM swaps are defined as commodities, swap agreements
[*1285] are exempt from all but the antifraud provisions of the CEA under the
CFTC Swap Exemption. Title V of the Futures Trading Practices Act of 1992
granted the CFTC the authority to exempt certain swaps transactions from CEAcoverage. 7 U.S.C. @ 6(c)(5).
In response to this directive, on January 22, 1993, the CFTC clarified its
July 1989 safe-harbor policy regarding swap transactions n5 in order to "promote
domestic and international market stability, reduce market and liquidity risks
in financial markets, including those markets [**41] (such as futures
exchanges) linked to the swap market, and eliminate a potential source of
systemic risk. To the extent that swap agreements are regarded as subject to the
provisions of the Act, the rules provide that swap agreements which meet the
terms and conditions [of the rules] are exempt from all provisions of the Act,
except section 2(a)(1)(B)." Exemption for Certain Swap Agreements, 58 Fed. Reg.
5587, 5588 (Jan. 22, 1993).
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n5 The CFTC identified those swap transactions that would not be regulated as
futures or commodity options transactions under the CEA to include those that
had 1) individually-tallored terms; 2) an absence of exchange-style offset; 3)
an absence of a clearing organization or margin system; 4) limited distribution
with the transaction undertaken in conjunction with the parties' lines of
business, thus precluding public participation; and 5) a prohibition against
marketing to the public. Policy Statement Concerning Swap Transactions, 54 Fed.
Reg. 30,694 (July 21, 1989).
- - - - - - - - - - - - - - - - -End Footnotes- - - - - - - - - - - - - - - - -
[**42]
To qualify for exemption, a transaction must fit within the CFTC's definition
and meet four criteria. The CFTC defines a "swap agreement" as
(i) An agreement (including terms and conditions incorporated by reference
therein) which is a rate swap agreement, basis swap, forward rate agreement,
commodity swap, interest rate option, forward foreign exchange agreement, rate
cap agreement, rate floor agreement, rate collar agreement, currency swap
agreement, cross-currency rate swap agreement, currency option, any other
similar agreement (including any option to enter into any of the foregoing);
(ii) Any combination of the foregoing; or
(iii) A master agreement for any of the foregoing together with all
supplements thereto.
17 C.F.R. @ 35.1(b) (1993). The 5s/30s and DM swaps fit within this definition.
The four criteria for exemption are: 1) The swap must be entered into solely
between "eligible swap participants;" 2) the swap may not be part of a fungible
class of agreements standardized as their material economic terms; 3)
counterparty creditworthiness is a material consideration of the parties in
entering into the swap agreement; and 4) the swap is not entered into and
[**43] is not traded on or through an exchange market. 17 C.F.R. @ 35.2
(1993).
The 5s/30s and DM swaps meet these criteria. First, the definition of
"eligible swap participants" in 17 C.F.R. @ 35.1(b)(2) includes a "bank ortrust company (acting on its own behalf or on behalf of another eligible swap
participant)" and corporations with total assets exceeding $ 10,000,000. BT and
P&G are within this definition. Second, these swaps are customized and not
fungible as they could not be sold to another counterparty without permission.
Third, creditworthiness is a consideration of the parties. Fourth, the swaps are
private agreements not traded on any exchange.
While exempting qualified swap agreements from CEA requirements such as
trading only on an exchange, the CFTC specifically reserved the antifraud
provisions in Sections 4b and 4o of the Act and Commission Rules 32.9, 17 C.F.R.
@ 32.9 (1992):
A swap agreement is exempt from all provisions of the Act and any person or
class of persons offering, entering into, rendering advice, or rendering other
services with respect to such agreement, is exempt for such activities from all
provisions of the Act (except in each case the [**44] provisions of sections
2(a)(1)(B), 4b, and 4o of the Act and @ 32.9 of this chapter ....
Id. (emphasis added).
Thus, even if the 5s/30s and DM swaps are exempt from other provisions of the
CEA, [*1286] they may be subject to the antifraud provisions (@ 4b and @
4o).
B. Violation of Section 4b (Count XII)
Section 4b of the Commodity Exchange Act, 7 U.S.C. @ 6b(a), makes it
"unlawful ... (2) for any person, in or in connection with any order to make, or
the making of, any contract of sale of any commodity for future delivery, made,
or to be made, for or on behalf of any other person ..." to engage in certain
fraudulent conduct.
BT asserts that Count XII, alleging a violation of Section 4b, should be
dismissed because BT did not act "for or on behalf of" P&G. Rather, BT "acted
solely as a principal, dealing with -- not for -- P&G on an arm's length basis."
P&G contends that BT's advertisements and representations are promises that
BT would use its experience, sophistication and expertise on behalf of its
clients to advise them in the complex financial area of leveraged derivatives.
P&G relies on Judge Friendly's decision in Leist v. Simplot, 638 F.2d 283 (2d
Cir. [**45] 1980), aff'd sub nom. Merrill Lynch, Pierce, Fenner & Smith,
Inc. v. Curran, 456 U.S. 353, 72 L. Ed. 2d 182, 102 S. Ct. 1825 (1982). Judge
Friendly noted, "None of the cases recognizing an implied right of action under
@ 4b suggest limitation to the broker-customer relation." Id. at 322. Thus, P&G
argues that the Leist decision expanded the implied right of action under @ 4b
to claims of fraud well beyond one who acts for or on behalf of another in the
customer-broker situation. Indeed, the defendant in Leist was the New York
Mercantile Exchange, and the U.S. Supreme Court in Curran did permit a private
action against that entity; however, the Court in Curran did not create a
blanket private right of action under @ 4b or delete the requirement that the
transaction must be conducted "for or on behalf of" the defrauded party. See
ACLI International Commodity Services, Inc. v. Banque Populaire Suisse, 550 F.
Supp. 144, 145 (S.D. N.Y. 1982) ("Unless the statute's plain language is to be
ignored, a @ 4b plaintiff must allege fraud in a commodities transactionconducted for himself, or on his own behalf."); but see Apex Oil Co. v. DiMauro,
641 F. Supp. 1246, 1286 [**46] (S.D. N.Y. 1986), aff'd in part, rev'd in
part on other grounds, 822 F.2d 246 (2d Cir. 1987), cert. den. 484 U.S. 977 (in
dicta, the district court stated that Judge Friendly's "expansive"
interpretation of @ 4b encompasses "brokered transactions between longs and
shorts so as to hold principals accountable to each other").
I conclude that BT was not acting for or on behalf of P&G as that
relationship is generally construed in the customer-broker context. As
counterparties, P&G and BT were principals in a bilateral contractual
arrangement. n6 This is not to say that BT had no duties to P&G. Those duties
are set out in Section VIII. below. However, P&G has no private right of action
under @ 4b.
C. Violation of Section 40 (Count XIII)
Section 4o, 7 U.S.C. @ 6o, provides:
(1) It shall be unlawful for a commodity trading advisor ... by use of the
mails or any means or instrumentality of interstate commerce, directly or
indirectly --
(A) to employ any device, scheme or artifice to defraud any client or
participant or prospective client or participant; or
(B) to engage in any transaction, practice, or course of business which
operates as a fraud or [**47] deceit upon any client or participant or
prospective client or participant.
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n6 In West Virginia v. Morgan Stanley & Co., 194 W. Va. 163, 459 S.E.2d 906,
913 (1995), the Supreme Court of Appeals of West Virginia noted in a case
involving derivatives transactions that as a counterparty, Morgan Stanley was a
"principal in the transactions at stake, not a broker."
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In Jarrett v. Kassel, 972 F.2d 1415 (6th Cir. 1992), cert den. 507 U.S. 916,
122 L. Ed. 2d 667, 113 S. Ct. 1272 (1993), the Sixth Circuit applied the holding
in Curran to @ 4o claims. The court in Jarrett held that, just as there is a
private right of action under @ 4b for an investor defrauded by his broker,
there is an implied private right of action under @ 4o against commodity trading
advisors and commodity pool operators. Id. at 1423. The question is whether BT
was P&G's commodity trading advisor.
[*1287] In 7 U.S.C. @ 1a(5)(A), the CEA defines "commodity trading advisor"
as: any person who
(i) for compensation [**48] or profit, engages in the business of advising
others, either directly or through publications, writing, or electronic media,
as to the value of or the advisability of trading in -- (I) any contract of sale of a commodity for future delivery made or to be
made on or subject to the rules of a contract market;
(II) any commodity option authorized under section 6c of this title; or
(III) any leverage transaction authorized under section 23 of this title; or
(ii) for compensation or profit, and as part of a regular business, issues or
promulgates analyses or reports concerning any of the activities referred to in
clause (i).
Section (I) of the definition does not apply because the 5s/30s swaps were
not traded on any contract market and are not subject to the rules of any
contract market under the Swaps Exemption. Section (II) refers to commodity
options authorized under section 6c. This provision prohibits all option trading
in commodities unless authorized by CFTC rules. 7 U.S.C. @ 6c. Because of the
Swaps Exemption, swaps are specifically exempt from CFTC rules. Thus, Section
(II) may not be applicable. Section (III) does not apply, because the 5s/30s and
DM swaps do not [**49] fit within the CFTC's regulations for leverage
contracts referred to in 7 U.S.C. @ 23(a). n7
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n7 See 17 C.F.R. @ 31.4(w) (leverage contracts must be for ten years or
longer).
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A commodity trading advisor is one who is "in the business of advising others
on the value or advisability of trading in the purchase or sale of futures
contracts or options" or as an "investment adviser." F.D.I.C. v. Hildenbrand,
892 F. Supp. 1317, 1324-35 (D. Colo. 1995). I recognize that representatives
from BT Securities had conversations with P&G regarding market conditions, past
performance of Treasury notes and bonds, prognostications for the future, and
the like. There is also evidence that these representatives gave P&G a sales
pitch regarding the potential benefits of their product. These representatives
also discussed P&G's view of interest rates. Thus, while BT Securities
representatives came close to giving advice, n8 P&G representatives used their
own independent knowledge of market conditions in forming their own [**50]
expectation as to what the market would do in the 5s/30s and DM swaps. That
expectation (central to the two swaps) was not based on commodity trading
advice. That expectation was clearly P&G's sole decision. Thus, P&G's claims in
Count XIII are dismissed.
- - - - - - - - - - - - - - - - - -Footnotes- - - - - - - - - - - - - - - - - -
n8 In response to an Offer of Settlement, the CFTC entered an Order against
BT Securities on December 22, 1994, with regard to an unspecified OTC derivative
transaction with Gibson Greetings, Inc. In re BT Securities Corporation, CFTC
Docket No. 95-2 (Dec. 22, 1994). The CFTC indicated that the facts were
sufficient to show that BT Securities had an advisory relationship with Gibson.
Apparently, Gibson did not understand the ramifications of the transaction, and
BT Securities was aware of that lack of financial sophistication. As with the
SEC Consent Order, the CFTC Order provides: "These findings are not binding onany other person or entity named as a defendant or respondent in any other
proceeding." Thus, while an indicator that the CFTC viewed BT Securities as a
commodity trading advisor as to Gibson, the CFTC's Order is not binding here.
- - - - - - - - - - - - - - - - -End Footnotes- - - - - - - - - - - - - - - - -
[**51]
D. Violation of 17 C.F.R. @ 32.9 (Count XIV)
Section 32.9 of the CFTC Rules, 17 C.F.R. @ 32.9, provides:
It shall be unlawful for any person directly or indirectly:
(a) To cheat or defraud or attempt to cheat or defraud any other person;
(b) To make or cause to be made to any other person a false report or
statement thereof ...;
(c) To deceive or attempt to deceive any other person by any means
whatsoever;
in or in connection with an offer to enter into, the entry into, or the
confirmation or the execution of, any commodity option transaction.
BT argues that there is no private right of action under the CFTC Rules.
Courts are divided on this question. Among those cases finding no such private
right of action are [*1288] Khalid Bin Alwaleed Foundation v. E.F. Hutton
Co., Inc., 709 F. Supp. 815, 820 (N.D. Ill. 1989) ("Congress did not intend
private rights of action for violations of CFTC rules."); Fustok v.
ContiCommodity Services Inc., 618 F. Supp. 1069, 1073-73 (S.D.N.Y. 1985) ("We
find nothing in the legislative history which indicates that Congress intended
the rights of the CFTC and the rights of investors to be identical;" thus,
plaintiff may not maintain [**52] an action based solely on violation of a
CFTC Rule.); see also Davis v. Coopers & Lybrand, 787 F. Supp. 787, 799 (N.D.
Ill. 1992) ("Plaintiffs effectively concede ... that with certain inapplicable
exceptions the exclusive private remedy under CEA @ 22 does not include a cause
of action for violation of CFTC Regulations."); In re ContiCommodity Services
Inc., Securities Lit., 733 F. Supp. 1555, 1568 (N.D. Ill. 1990) ("Claims for
violation of CFTC regulations can only be pursued in reparation proceedings
under @ 14 of the CEA [7 U.S.C. @ 18], not in civil actions for damages pursuant
to @ 22.").
Cases implicitly finding a private right of action for violation of CFTC
Rules are the following: Irvine v. Cargill Investor Services, Inc., 799 F.2d
1461, 1462 n.3 (11th Cir. 1986) ("There probably is a [private cause of action
under CFTC regulations]..."); Point Landing Inc. v. Omni Capital Int'l, Ltd.,
795 F.2d 415, 418 n. 4 (5th Cir. 1986), aff'd sub nom. Omni Capital Int'l Ltd.
v. Rudolph Wolff & Co., Ltd., 484 U.S. 97, 98 L. Ed. 2d 415, 108 S. Ct. 404
(1978) ("Transactions on the London Metals Exchange have been held outside the
scope of @ 4c(b) of the CEA. [**53] The plaintiffs' claims may, however, be
cognizable under @ 4c(b) of the Act, 7 U.S.C. @ 6c(b) and Regulation 32.9, 17
C.F.R. @ 32.9, or under Regulation 30.02, 17 C.F.R. @ 30.02." (citations
omitted)). These cases are hardly a ringing endorsement of a private cause of
action under the CFTC Regulations. The better reasoned rule of law is that @ 32.9 is applicable only to CFTC
enforcement actions and does not give rise to a private cause of action for
violation of that Regulation. Therefore, Count XIV of P&G's Second Amended
Complaint is dismissed.
VII. Ohio Deceptive Trade Practices Act (Count XV)
The Ohio Deceptive Trade Practices Act, Ohio Rev.Code @ 4165.02, provides:
A person engages in a deceptive trade practice when, in the course of his
business, vocation or occupation, he ...
(E) Represents that goods or services have ... characteristics, ... uses,
benefits or quantities ... that they do not have ...;
(G) Represents that goods or services are of a particular standard, quality,
or grade ..., if they are of another.
This claim is dismissed because of the mandate in the contract. The ISDA
Master Agreement provides in Section (1) of Part 4 of the [**54] Schedule:
Governing Law. This Agreement will be governed by, and construed and enforced in
accordance with, the laws of the State of New York without reference to choice
of law doctrine.
The inclusion of the phrase "without reference to choice of law doctrine"
forecloses the application of Ohio law.
In Turtur v. Rothschild Registry Int'l., Inc., 26 F.3d 304, 309 (2d Cir.
1994), the court considered the following choice of law provision:
This note shall be governed by, and interpreted under, the laws of the State of
New York applicable to contracts made and to be performed therein without giving
effect to the principles of conflict of laws. The parties hereto consent to the
exclusive jurisdiction of the courts of the State of New York to resolve any
controversy or claim arising out of or relating to this contract or breach
thereof.
The U.S. Court of Appeals for the Second Circuit enforced the parties' agreement
to be bound by their choice of law provision, without regard to conflict of laws
principles, and applied New York law to the fraud claim that arose out of or
related to their contract. Id. at 310.
Relying on Turtur, the U.S. District [**55] Court for the Southern
District of New York construed [*1289] a similar provision in an ISDA Master
Agreement. P.T. Adimitra Rayapratama v. Bankers Trust Co., 1995 U.S. Dist. LEXIS
11961; Comm. Fut. L. Rep. (CCH) P26,508 (S.D. N.Y. 1995). This ISDA Agreement
was governed by English Law, which does not recognize RICO (Racketeer Influenced
Corrupt Organizations Act) and commodities laws claims under U.S. statutes, and
the court accordingly dismissed plaintiff's statutory claims.
Similarly, the U.S. Court of Appeals for the Sixth Circuit dismissed claims
of violation of Alabama statutes where the contract was to be governed by
Michigan law. Moses v. Business Card Express, Inc., 929 F.2d 1131, 1139-40(6th Cir.), cert. den. 502 U.S. 821, 116 L. Ed. 2d 54, 112 S. Ct. 81 (1991).
The reasoning in these cases applies here. The parties consented to be bound
by New York statutes and caselaw, without regard to any choice of law doctrine.
Therefore, there is no claim under Ohio statutes, and Count XV is dismissed.
VIII. The Duties and Obligations of the Parties
P&G contends that a fiduciary relationship existed between it and BT. It
argues that it agreed to the swap transactions [**56] because of a long
relationship it had with BT and the trust that it had in BT, plus the assurance
that BT would take on the responsibility of monitoring the transactions and that
BT would look out for its interests.
P&G points to its trust in BT in that it divulged confidential corporate
information to BT. By entering into complex swaps transactions with BT, which
represented itself as experts in such transactions, P&G relied on that expertise
and BT statements that it would tailor the swaps to fit P&G's needs. Even
accepting these contentions as true, these contentions fail. New York caselaw is
clear.
In Beneficial Commercial Corp. v. Murray Glick Datsun, Inc., 601 F. Supp.
770, 772 (S.D. N.Y. 1985) that law is summarized with case citations as follows:
New York law is clear that a fiduciary relationship exists from the assumption
of control and responsibility and is founded upon trust reposed by one party in
the integrity and fidelity of another. No fiduciary relationship exists ...
[where] the two parties were acting and contracting at arm's length. Moreover,
courts have rejected the proposition that a fiduciary relationship can arise
between parties to a business [**57] relationship.
P&G and BT were in a business relationship. They were counterparties. Even
though, as I point out hereafter, BT had superior knowledge in the swaps
transactions, that does not convert their business relationship into one in
which fiduciary duties are imposed. Thus, I grant summary judgment on Count IV
in favor of BT.
This does not mean, however, that there are no duties and obligations in
their swaps transactions.
Plaintiff alleges that in the negotiation of the two swaps and in their
execution, defendants failed to disclose vital information and made material
misrepresentations to it. For these reasons plaintiff has refused to make any
payments required by the swaps transactions to defendants. Plaintiff requests
that a jury verdict should declare that it owes nothing to defendants. Put
another way, the damage which plaintiff claims is the amount of money it would
have to pay to defendants if the jury verdict is against its position.
Since plaintiff's Amended Complaint is based on allegations of defendants'
fraud and material misrepresentations, I must determine what the duties and
obligations of the parties are to each other.
This requires 1) an analysis [**58] of the written contracts between the
parties, i.e., the International Swap Dealers Association ("ISDA") Agreementof January 20, 1993, the Schedule and Definitions appended to it, and the
detailed Confirmations as to each swap; 2) the statutes and caselaw of New York
(the parties in the ISDA Agreement and Part 4 of the Schedule, having contracted
that "this Agreement will be governed by, and construed and enforced in
accordance with, the laws of the State of New York without reference to choice
of law doctrine"); and 3) the Uniform Commercial Code as well as the [*1290]
Restatement (Second) Contracts, the Code having been made a part of New York
statutory law and the principles of the Restatement having been accepted by New
York courts.
I note, at the outset, that plaintiff's complaint does not clearly state a
cause of action based on breach of contract; plaintiff rather alleges fraudulent
conduct and material misrepresentation, and alludes to this as tortious wrong. I
recognize that plaintiff can put in its proofs on either basis.
The analysis to be made is necessary to an understanding of the underpinning
that gives rise to the duties and obligations of the parties in the swap
[**59] transactions.
I turn first to the written agreement. The sections in the ISDA Agreement
that appear to be relevant to these swap transactions are as follows:
In Section 3.(a)(v), this appears: "Obligations Binding. Its obligations
under this Agreement ... to which it is a party constitute its legal, valid and
binding obligations, enforceable in accordance with their respective terms ...."
Section 4., which reads: "Each party agrees with the other that so long as it
has or may have any obligation under this Agreement ... to which it is a party:
(a) It will deliver to the other party: (ii) any other documents specified in
Part 3 of the Schedule or any Confirmation."
Section 9.(d), which reads: "Except as provided in this Agreement, the
rights, powers, remedies, and privileges provided in this Agreement are
cumulative and not exclusive of any rights, powers, remedies, and privileges
provided by law." (Emphasis added).
Under Section 4., each party must furnish specified information and that
information must also relate to any documents specified in any Confirmation.
Documents that are referred to in the Confirmation (here I allude specifically
to the documents that will enable [**60] a party to determine the correlation
between the price and yields of the five-year Treasury notes and thirty-year
Treasury bonds, the sensitivity tables, the spreadsheets regarding volatility,
and documents relating to the yield curve) should be provided.
I turn to the statute law of New York. The Uniform Commercial Code, as part
of New York statute law, particularly Section 1-203, states: "Every contract or
duty written in this Act imposes an obligation of good faith in its performance
or enforcement." New York has also adopted the principles in the Restatement
(Second) Contracts, @ 205, that every contract imposes upon each party a duty of
good faith and fair dealing in its performance and enforcement. Id.
New York caselaw establishes an implied contractual duty to disclose in
business negotiations. Such a duty may arise where 1) a party has superior
knowledge of certain information; 2) that information is not readily availableto the other party; and 3) the first party knows that the second party is acting
on the basis of mistaken knowledge. Banque Arabe et Internationale
D'Investissement v. Maryland National Bank, 57 F.3d 146 (2d Cir. 1995). In that
case, the U.S. [**61] Court of Appeals for the Second Circuit refers to New
York cases which establish that implied duty.
Additional cases which explicate the duty to disclose indicate that a duty
may arise when one party to a contract has superior knowledge which is not
available to both parties. Young v. Keith, 112 A.D.2d 625, 492 N.Y.S.2d 489, 490
(N.Y.A.D. 3 Dept. 1985); Haberman v. Greenspan, 82 Misc. 2d 263, 368 N.Y.S.2d
717 (N.Y.Sup. 1975). These cases are discussed in Allen v. West Point Pepperell,
Inc., 945 F.2d 40 (2d Cir. 1991). Even though a fiduciary duty may not exist
between the parties, this duty to disclose can arise independently because of
superior knowledge. See Carvel Corp. v. Diversified Management Group, Inc., 930
F.2d 228 (2d Cir. 1991) ("Under New York law, every contract contains an implied
covenant of good faith and fair dealing." (citing cases)). See also Unigard Sec.
Ins. Co., Inc. v. North River Ins. Co., 4 F.3d 1049 (2d Cir. 1993) (under New
York law, the duty to deal fairly and in good faith requires affirmative action
even though not expressly provided for by the agreement. In this case, that
affirmative action was the necessity of providing certain [**62] notice.).
[*1291] Thus, I conclude that defendants had a duty to disclose material
information to plaintiff both before the parties entered into the swap
transactions and in their performance, and also a duty to deal fairly and in
good faith during the performance of the swap transactions. I confine these
conclusions to the parameters outlined in this opinion.
One final point must be made. No matter how plaintiff proceeds to prove its
case, under New York law the burden of proving fraud requires clear and
convincing evidence, and not mere preponderance. See Almap Holdings v. Bank
Leumi Trust Co. of N.Y., 196 A.D.2d 518, 601 N.Y.S.2d 319 (N.Y. App.Div. 1993),
Iv. denied 83 N.Y.2d 754, 612 N.Y.S.2d 378, 634 N.E.2d 979 (1994); Hudson
Feather & Down Prods. v. Lancer Clothing Corp., 128 A.D.2d 674, 675, 513
N.Y.S.2d 173 (N.Y. App. Div. 1987); Orbit Holding Corp. v. Anthony Hotel Corp.,
121 A.D.2d 311, 314, 503 N.Y.S.2d 780 (N.Y. App. Div. 1986). This evidentiary
standard demands "a high order of proof" (George Backer Mgmt. Corp. v. Acme
Quilting Co., 46 N.Y.2d 211, 220, 413 N.Y.S.2d 135, 385 N.E.2d 1062 (1978)) and
forbids the awarding of relief "'whenever the evidence is [**63] loose,
equivocal or contradictory'".
IX. Negligent Misrepresentation and Negligence (Counts III and V)
BT also moves for summary judgment as to P&G's claims of negligent
misrepresentation and negligence. Reference to New York caselaw demonstrates
that these claimed causes of action are not available to P&G.
A line of New York cases holds:
Under New York law, there is no cause of action for negligent misrepresentation
in the absence of a special relationship of trust of confidence between the
parties. Neither an ordinary contractual relationship nor a banking
relationship, without more, is sufficient to establish a "special relationship,"
which only occurs in the context of a previous or continuing relationship
between the parties.Banque Arabe et Internationale D'Investissement v. Maryland National Bank, 819
F. Supp. 1282, 1292-93 (S.D.N.Y. 1993), aff'd 57 F.3d 146 (2d Cir. 1995)
(citations omitted). In this case, the court found no "special relationship"
between two "sophisticated financial institutions that came together solely to
engage in an arm's length transaction." Id. at 1293; Banco Espanol de Credito v.
Security Pacific Nat'l Bank, [**64] 763 F. Supp. 36, 45 (S.D.N.Y. 1991) ("In
the case of arm's length transactions between large financial institutions, no
fiduciary relationship exists unless one was created in the agreement.").
BT and P&G are sophisticated corporations whose dealings were on a business
level. Theirs was not a "special relationship" that would support a claim of
negligent misrepresentation under New York law.
In support of its negligence claim, P&G urges application of the malpractice
provision of Restatement (Second) Torts, @ 299A, which states:
Unless he represents that he has greater or less skill or knowledge, one who
undertakes to render services in the practice of a profession or trade is
required to exercise the skill and knowledge normally possessed by members of
that profession or trade in good standing in similar communities.
Courts in New York have rarely applied @ 299A. See Heine v. Newman, Tannenbaum,
Helpern, Syracuse & Hirschtritt, 856 F. Supp. 190, 195 (S.D.N.Y. 1994) (attorney
malpractice); Roizen v. Marder's Nurseries, Inc., 161 Misc. 2d 689, 615 N.Y.S.2d
235 (Sup. Ct. 1994) (motion to dismiss claim of tree surgeon malpractice
denied).
I decline to [**65] apply @ 299A to this action; rather, the duties and
obligations of BT are stated in Section VIII above.
P&G also relies on Brown v. Stinson, 821 F. Supp. 910 (S.D.N.Y. 1993), where
the court allowed a claim of negligent execution of a transaction. The court
stated, "Having made such a proposal [to execute a transaction on plaintiff's
behalf], defendant undertook the duty to act with due care." This case is
distinguished because it involved a non-contractual, gratuitous relationship.
The rights and duties of P&G and BT, on the other [*1292] hand, are based in
contract. Where the parties' relationship is contractual, and the duty of good
faith and fair dealing is implied in the contract, a negligence claim is
redundant.
Thus, summary judgment in favor of BT is granted on Counts III and V.
X. Conclusion
To summarize these rulings, I grant dismissal under Fed.R.Civ.P. 12(b)6 as to
Counts VII - XV, and summary judgment as to Counts III, IV, and V.
But these rulings should not be misinterpreted. While they are required by
the case management rules of civil procedure, plaintiff's case will proceed to
trial.
The rulings have, in part, been made necessary because of the position
[**66] of the litigants as parties. In this case, BT claims that P&G owes it over $ 200 million and refuses to
pay. P&G says that it owes nothing because it was defrauded. Ordinarily one
would expect the BT defendants to be party plaintiffs and P&G to be a party
defendant. This unusual posture of the parties has caused some confusion which,
it is hoped, these rulings will dispel.
Put another way, one would expect BT to sue and P&G to defend because of the
alleged fraud. Thus, a verdict in favor of BT as plaintiffs would require
payment by P&G; while a verdict for P&G as defendant would mean that it would
owe nothing to BT.
Jury instructions will hopefully clarify this for the jury.
IT IS SO ORDERED.
John Feikens
United States District Judge
Dated: May 8, 1996