The initial reaction to the surprise legal opinion filed in the Procter & Gamble/Bankers Trust derivatives litigation settled last week is that Bankers Trust and the dealer community won most of the key legal issues. However, the issue Bankers Trust lost - relating to its legal obligation to disclose to P&G material information the bank possessed superior knowledge of - may have the greatest impact on the burgeoning derivatives markets.
Within minutes of the announcement of the settlement, both sides were putting their own spin on the dollar settlement. P&G asserted that Bankers Trust ended up satisfying 83 percent of P&G's $195 million derivatives losses; Banker Trust contended that it ended up paying only 74 percent.
However, that debate will soon be eclipsed by the one surrounding the legal opinion issued by Federal District Court Judge John Feikens. Normally, a legal opinion is not issued when a controversy is settled prior to trial and it appears that neither side was aware of Judge Feikens' ruling when they agreed to the settlement. The surprise opinion, which responded to Bankers Trust's pretrial motions, may prove to be a landmark because it is the first time that an American court has ruled on a number of critical legal issues affecting the multi-trillion dollar derivatives markets. Like the results of a hotly contested New Hampshire presidential primary, both the cash settlement and surprise legal opinion will be minutely scrutinized. People will be spinning this one for a long time.
The initial question many will ask is whether the cash settlement would - or should - have been different if Judge Feikens' decision had been known to the parties. By the numbers, the opinion appears to constitute a one- sided victory for Bankers Trust's legal positions. Judge Feikens granted Bankers Trust's motion to dismiss all of P&G's federal securities law and commodities law claims, as well as its claims under Ohio law. This essentially left for trial P&G's claims that it was entitled to recover its losses based upon its contract and fraud claims under New York law.
However, as is the case with New Hampshire primary election results, looking at Judge Feikens' opinion solely "by the numbers" ignores the expectations of the parties. The dealer community has long subscribed to the view that neither the Securities and Exchange Commission nor the Commodity Futures Trading Commission has jurisdiction over privately negotiated over-the-counter derivatives contracts. Thus, Judge Feikens' rulings on the federal issues might be cause for relief, but not jubilation. Indeed, the relief may be short-lived; Washington policymakers may promptly seek to close the large gaps identified in Judge Feikens' opinion with respect to federal oversight of these important financial markets.
The truly significant aspect of Judge Feikens' opinion is his analysis of the duties and obligations of the parties to over-the-counter derivatives contracts under New York law. Here the dealers did not fare nearly as well. Derivatives dealers have generally taken the positions that:
*They have no fiduciary obligation to assess whether their products are suitable to the needs of their end-user customers.
*They are under no duty to disclose to their end-user counterparties material information (of which they have superior knowledge) concerning the terms, risks, and pricing of proposed derivatives transactions.
These views are perhaps best articulated in the controversial code of conduct for over-the-counter financial transactions developed by six trade groups this past year under the auspices of the Federal Reserve Bank of New York. Judge Feikens' opinion supports the dealers' position with respect to fiduciary duty, but rejects, as a matter of clear New York law, their position with respect to disclosure.
By virtue of its "superior knowledge of certain information," Judge Feikens concluded, Bankers Trust "had a duty to disclose material information" to P&G both before the parties entered into the disputed transactions and during the course of their performance.
Every dealer must now consider the implications of Judge Feikens' decision for the tens of thousands of derivatives transactions entered into each year that are governed by New York law.
A prudent dealer simply cannot afford to assume the legal risk of ignoring Judge Feikens' holding regarding disclosure. As to what exactly must be disclosed, there is not a clear answer; nor is there any regulatory body to which the dealers can turn for definitive, practical guidance.
Perhaps the best starting point is the enforcement agreement entered into between Bankers Trust and the Federal Reserve Bank of New York in 1994. Under this agreement, Bankers Trust is required to "provide customers with sufficient information to understand the nature and material terms, conditions, and risks of" the complex derivatives transaction entered into with its customers.
The dealer community has taken various steps, and committed substantial energy and resources, over the past year and half to ensure that disclosure obligations of the type reflected in the Bankers Trust enforcement agreement would not become the standard for conducting business in the over-the-counter derivatives markets. Even the Federal Reserve Bank of New York has indicated that the requirements set out in the Bankers Trust enforcement agreement were not an attempt to establish new obligations for derivatives dealers generally.
Well, the only court to have ever spoken to this matter has now firmly stated that dealers must disclose material information of which they have superior knowledge to their end-user counterparties. However you want to spin it, this makes good common sense and represents a victory for the end- user community.
End-users should be responsible for their investment and hedging decisions, but those decisions should be informed ones based upon full and accurate disclosure of material terms and risks by their dealer counterparties.
Warren Davis is a partner in the Washington office of Sutherland, Asbill & Brennan. He regularly represents end-users of derivatives and serves as counsel to the End-Users of Derivatives Association. The views expressed in the article are his own and do not necessarily represent the views of the derivatives users group.