oversight

OTC Derivatives: Lawsuits Involving Sales Practice Concerns

Published by the Government Accountability Office on 1997-12-19.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

            United States
            General Accountixig Office
            Washington, D.C. 20548

             General Government Division

             B;278814

             December 19, 1997             -
                                         < :
             The Honorable Thomas J. Bliley
             C-an,      Committee on Commerce
             House of -Representatives-. -

             Subject: OTC Derivatives: Lawsuits Involving Sales Practice Concerns

            -‘Dear Mr. Chairman:

             This letter responds to a request made by your office during an October 16,
             1997, briefjng on our report OTC Derivatives: Additional Oversight Could
             k                                        (GAO/GGD-98-5, Oct. 2, 1997). This
             report addressed sales practices related to over-the-counter (OTC) derivatives,
             mortgage-backed securities (MBS), and structured notes. It included a
             discussion of lawsuits involving sales practices concerns, and your office asked
             us to provide a list of these lawsuits that describes the allegations made and the
             case outcomes.

            We produced the enclosed list from a database.of 360 losses involving OTC
            derivatives, MBS, and structured notes which we had compiled while working
            on our report1 To address your office’s request, we identified 13 OTC
            derivatives losses from this database that involved lawsuits in which the end-
            users had raised sales practice concerns. To determine the status of cases that
            were unresolved when we issued our report, we contacted SW from the
            relevant dealers and obtained information from public sources, including court


             ‘Our database of end-user losses was compiled from publicly available
            ‘information and regulatory data, including information taken from periodical
             and industry publications, special studies, litigation reporting services, and
             regulatory ease data The list was limited to end-user losses directly
             involving the products included in our report: OTC derivatives (forwards,
             options, and swaps), MBS, or structured notes. It excluded losses that
             dealers incurred or losses incurred by foreign end-users transacting with
             foreign dealers. The number and total dollar amount of losses in this list
             may be overstated as a result of including unrealized losses or losses
        .    partially att&utable to products other than those addressed in the report.
*I”          These losses may also be understated to the extent that all losses were not
   :.       publicly reported.         w
            i”                        r’- 8,         i              _.-
                                                     GAO/GGD-98-43Rz   OTCDerivativesLawsuit
B-278814                                                            -

documents, j&rnal articles, and/or press reports. We did not seek agency comments on
this letter because we had already received extensive comments from all interested
parties as part of preparing our report

The enclosure to this letter presents additional information on the 13 lawsuits involving
OTC derivatives sales practices. Of the 13 lawsuits, 6 involved Bankers Trust and the
remainder involved several U.S. securities firms. The claims made in the lawsuits
generally included statebased claims of fraud, breach.of fiduciary duty, and
misrepresentation, but seven cases also involved claims under federal laws, including              .
fraud and other claims under the Commodity Exchange Act (CEA) or the Securities
Exchange Act of 1934 (Exchange Act). In addition, the end-users in four of the cases
claimed that their personnel had not been authorized to enter into the transactions.
Three of the 11 cases are ongoing.                               ,.



It is our understanding, based on conversations with your office; that our recently issued
sales practice report, our briefing to your office, and this letter respond to the questions
raised in your November 14, 1995, request regarding OTC derivatives sales practices. We
plan to distribute copies of this letter to the Ranking Minority Member of your Committee
and the Chairman and Ranking Minority Member of the Subcommittee on Finance and
Hazardous Materials. In addition, we will provide copies to the Commodity Futures
Trading Commission, the Federal Reserve, and the Securities and Exchange Commission,
as well as others on request.

Major contributors to this letter were Cecile 0. Trap; Assistant Director; Cody J. Goebel,
Senior Evaluator; and Melvin Thomas, Senior Evaluator. Please contact me at (202) 512-
8678 or Cecile Trop at (312) 220-7705,if you or your staff have any questions.
           1
Sincerely,



Thomas McCool
Director, Financial Institutions        -
 and Markets Issues

Enclosure




2                                                     hAO/GGD-9%43R     OTC Derivatives Lawsuits
                                                                                   .c
                                                                                   ‘_
:Enclosure                                                                                                                                                Enclosure
                                        OTC Derivatives LossesInvolvina SalesPractice-Relatedlawsuits

    L

        Entity or          Loss        Specific type
        individual         amount      of derivative      Relevant lawsult claims,
    Jo. reporting losses   (millions)” product            defenses, or counterclaitis     Dealer    ,        Outcome. of lawsuit
    I   RCS Editori             $371 Interest rate and Fraud, breach of fiduciary duty, Bankers Trust        The parties settled for an undisclosed amount.
        (Italy)                      currency swaps and fraud under Italian
                                                       securities law
    !   Henryk de               $300 Currency             Breach of fiduciary duty; :      Bear Stearns      Ongolng. In a ruling on the defendant’s motion to
        Kwiatowski                   forwards and         negligence; fraud; negligent                       dismiss, the U.S. District Court for the Southern
                                     options      :.,     misrepresentation; breach of                       District of New York allowed to stand the plaintiff’s
                                                        1 contract; and various violations                   claims related to breach of fiduciary duty,
                                                          of the CEA, including fraud in                     negligence, and the count relating to fraud by a
                                                          connection with the sale of                        commodities trading advisor (section 40). The
                                                          commodities for future delivery                    court’s ruling dismissed the claims of fraud,
                                                          (section 4b), fraud by a                           negligent misrepresentation, breach of contract, ant
                                                       * commodities trading advisor                         the other CEA-related claims of fraud under section
                                           *              (section 40) and dealing in                        4b and illegal futures dealing.
                                                          illegal off-exchange futures
    3   State of West           $280 Treasury             Fraud                           Greenwich      ’   The other dealers settled with the state for a total a
        Virginia                     options                                              Capital            528 million, but after a jury trial in the Circuit Court
                                                                                          Markets,           of Kanawha County, West Virginia, Morgan Stanley
                                                                                          Goldman            was ordered to pay the state $56 million. The
                                                                                          Sachs, Morgan      Supreme Court of Appeals of West Virginia
                                                                                          Stanley,           overturned the lower court’s ruling and ordered a
                                               1                                          NatWest            new trial. Morgan Stanley subsequently settled
                                                                                          Government         with the state for $20 million.         ’
                                                                                          Securities, and
                                                                                          Salomon
                                                                                          Brothers                  t     z




3                                                                                                                       GAOIGGD-98-43R     OTC Derivatives    J.awsuits
Enclosure                                                                                                                                               Enclostire

        Entity or          Loss         Speclflc type
        individual         amount       of derivative   Relevant lawsuit claims,
    Uo. reporting losses   (millions)   product         defenses, or counterclaims      Dealer           Outcome of lawsuit
    I   Procter & Gamble        $157 Interest rate      Fraud, breach of fiduciary duty, Bankers Trust   In ruling on a motion by Bankers Trust, the U.S.
                                     swaps              negligence, misrepresentation,                   District Court of the Southern District of Ohio
                                                        fraud in connection with the                     dismissed or found in favor of the dealer on all
                                                        sale of a security under the                     securities and commodities law counts and left
                                                        Exchange Act, and violations of                  counts related to fraud and contract validity to be
                                                        the CEA’s general fraud section                  tried. On the day the ruling was issued, the two
                                                        (4b) and fraud by a                              parties settled, with Bankers’Trust forgtvtng about
                                                        commodities trading advisor                      $150 million of the $200 million that it was owed by
                                                        (40)                                             Procter & Gamble.
    5   PT Dharmala               $64 Interest rate     Misrepresentation, breach of    Bankers Trust    The Commercial Court of England ruled in favor of
        Saktl Sejahtera               swaps             contract, breach of duty of                      Bankers Trust, indicating that the dealer owed no
        (Indonesia)                                     care, and transactlon                            duties beyond that of ensuring that the facts In any
                                                        conducted with unauthorized                      representations were made fairly and accurately.
                                                        end-user personnel                               The parties subsequently settled for an undisclosed
                                                                                                         amount.
                                                        Fraud, breach of fiduciary duty, Lehman          Ongoing.                                /
    i   Minmetals                 $52 Currency
                                      options and       transaction conducted with       Brothers
                                      swaps             unauthorized end-user
                                                        personnel, and fraud under the
                                                        Exchange Act and the CEA
    I   UNIPEC                    $44 Currency swaps Fraud, breach of fiduciary duty, Lehman             The parties settled for an undisclosed amount.
                                                     transaction conducted with       Brothers
                                                     unauthorized end-user                                                                     /
                                                     personnel, and fraud under the
                                                     Exchange Act and the CEA
    I   Seita ~,,             ,,, $30 Interest,rate and Misrepresentation, breach of    Salomon      ’ Ongoing. if,
                                      currency swaps fiduciary duty, negligence, and    Brothers                ‘i                                 ~:
                                                        breach of contract


                                                                                                                                 I I.




4                                                                                                                GAO/GGD-98-43R         OTC Derivatives Lawsuiti
Enclosure                                                                                                                                          Enblosure

     Entlty or            Loss        Specific type
     individual           amount      of derivative   Relevant lawsuit claims,
 So. reporting losses     (mllllons)’ product         defenses, or counterclaims       Dealer          Outcome of lawsuit                   ‘.
 I    Lastlo Tauber              $26 Currency         Fraud, breach of fiduciary duty, Salomon         In a ruling later affirmed by .the Fourth Circuit Court,
                                     swaps,           violations of state bucketing    Brothers        the US. District Court for the Eastern District of
                                     forwards, and    and gambling laws, and                           Virginia rejected all of Tauber’s state-based
                                     options          transactions in dispute were                     defenses and counterclaims. In addition, the court
                                                      illegal off-exchange futures and                 concluded that the disputed transactions were
                                                      options under the CEA                            exempt from the CEA and thereby rejected all of
                                                                                                       the counterclaims asserting that the dealer had
                                                                                                       violated the CEA.
 IO   Gibson Greetings,          $21 Interest rate    Fraudulent concealment,         Bankers Trust    The parties settled, with Bankers Trust forgiving
      Inc.                           swaps and        breach of fiduciary duty,                        $14 million of the $21 million owed to it by Gibson
                                     options          reckless and negligent                           Greetings.
                                                      misrepresentation, and
                                                      violations of the CEA’s general
                                                      fraud section (4b) and fraud by
                                                      a commodities trading advisor
                                                      (40)
 1    Sinochem                   $20 Interest rate    Transaction conducted with       Lehman          The parties settled for an undisclosed amount.
                                     swaps            unauthorized end-user            Brothers
                                                      personnel
 2    PT Adimitra                $16 Interest rate    Breach of fiduciary duty,        Bankers Trust   The U.S. District Court for the Southern District of
      Rayapratama                    swaps            professional negligence,                         New York dismissed the federal commodities and
                                                      negligent misrepresentation,                     RICO claims because they were precluded by the
                                                      violation of the CEA                             parties’contractual choice of the Iah of England.
                                                      commodities trading advisor                      The court also dismissed the common law claims
                                                      fraud section (40)                               that remained because the dismissal of the federal
                                                      and violation of the Racketeer                   law claims removed its jurisdiction over those
                                                      Influenced and Corrupt                           claims. The parties subsequently settled for an
                                                      Organizations Act (RICO)                         undisclosed amount.




                                                                                                                GAO/GGD-9843R        OTC Derivatives   Lawsuits
Enclosure                                                                                                                                       Enclosure

        EntIty or          Loss        Specific type
        individual         amount      of derivative   Relevant lawsuit claims,
    No. reporting losses   (millions)” product         defenses, or counterclaims     Dealer          Outcome of lawsuit
    13   Equity Group             $11 Interest rate    Negligent misrepresentation    Bankers Trust   The parties settled for an undisclos’ed amount.
         Holdings                     (bond) options   and breach of flduclary duty     .’


?‘he loss amounts reported may include realizedltisses, unrealizedlosses,losses arising ifi p& fro& pro&As or activities other than
OTC derivatives, or the amount of the loss may be in dispute.                                 t;

Sources: Court documents,journal articles, press accounts,knd interviews with dealer officiak.




(233661)

6                                                                                                             GAO/GGD8843R       OTC Derivatives   Lawsuits
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