On May 8, 1996, Judge John Feikens issued an opinion in the Procter & Gamble/Bankers Trust litigation that already has been the subject of considerable attention.
In a May 17 editorial on the federal judge's opinion, The Wall Street Journal stated that "Main Street scored one Thursday in the war over swaps" because the "underlying message is that swaps customers should buy what they need."
According to the Journal, "big sophisticated players need little fiduciary protection," and there is no need "to blanket an entire industry with a corps of superfluous police."
Four days later, a comment in the American Banker by Warren Davis had a very different emphasis. First, Mr. Davis described the "relief" of the dealer community concerning the dismissal of the federal securities law and commodities law claims. According to Mr. Davis, this relief, however, may be "short-lived" because "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."
Secondly, Mr. Davis described the most significant aspect of the opinion as a statement "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 victory for the end-user community."
What exactly did Judge Feikens do? Did he signal a need for greater federal regulation of swaps and increased disclosure obligations for dealers applicable to many swaps transactions? Or did he clarify both the legal status of swaps and the freedom of sophisticated parties to establish by contract the nature of their relationship?
Judge Feikens did not identify any large gaps in federal regulation. Instead he ruled that the transactions in question were not securities and that P&G did not have private rights of action under the federal commodities laws. These correct and long-anticipated rulings do not change the legal or regulatory landscape for swaps in the United States.
There has been no demonstration of a need for federal regulation of relationships between dealers and end users. Our securities laws at their core protect and provide fairness for individual investors in securities, while swaps overwhelmingly involve sophisticated entities as dealers and end users in transactions that entail bilateral extensions of credit.
Our commodities laws at their core regulate trading on exchanges of standardized futures transactions, while swaps involve individually tailored and separately negotiated transactions.
Many important financial transactions are conducted daily by institutions without federal regulation of the relationship, including bank lending activities and foreign exchange transactions. Swaps are simply another type of transaction that fit this approach.
As indicated by the opinion of Judge Feikens, swaps are private contracts that fall outside the special legal framework Congress has applied by statute to certain categories of financial instruments.
Congressional leaders have recognized that no comparable statutory regime is needed for swaps. One reason for that conclusion is the institutional oversight of swap dealers by various regulatory agencies.
The U.S. banking regulators have played and continue to play an active supervisory role over the swap activities of U.S. banks, including banks that are dealers. The SEC has made proposals for derivatives disclosure by mutual funds and market risk disclosure (including for derivatives) by registrants under the Securities Act and the Securities Exchange Act.
And six broker-dealers developed a voluntary oversight framework for the over-the-counter derivatives activities of their affiliates that act as swap dealers. This framework was published by the Derivatives Policy Group in March 1995 in cooperation with the Securities and Exchange Commission and the Commodity Futures Trading Commission.
There thus is ample institutional regulation of dealers, and no need has been demonstrated for functional regulation of swap activities.
As demonstrated by the Procter & Gamble/Bankers Trust litigation, participants in swap transactions have ample redress for alleged fraudulent behavior through common law contract and fraud claims. Judge Feikens clarified this point by means of a series of rulings that separated out or dismissed Procter & Gamble's claims under the Racketeer Influenced and Corrupt Organizations Act, federal securities and commodities statutes, state securities and deceptive trade practices laws; those for punitive damages, and those alleging negligent misrepresentation and fiduciary relationship.
Once this plethora of unsupported legal theories was reduced to the common law basics, the true legal basis for the dispute between the parties was established.
There are important messages for both dealers and end users in what Judge Feikens had to say about the remaining claims.
In limited circumstances, a dealer may have an implied contractual duty to disclose certain information to its counterparty during negotiations. That duty, according to Judge Feikens, "may arise where a party has superior knowledge of certain information; that information is not readily available to the other party; and the first party knows that the second party is acting on the basis of mistaken knowledge."
This statement from the leading case cited by Judge Feikens serves as a warning to dealers to proceed with caution when negotiating a complex transaction with a counterparty that the dealer knows is acting on the basis of a misunderstanding.
The Principles and Practices for Wholesale Financial Market Transactions, which are maligned by Mr. Davis, contain a similar admonition to dealers. These guidelines urge dealers for their own protection (in order to avoid litigation and other risks) to maintain policies and procedures to address situations where a counterparty does not have the capability to understand a particular transaction.
Judge Feikens' decision, however, can properly be read as having implications for only a few of the many swaps and other OTC derivatives transactions entered into every year that are governed by New York law, because in the vast majority of those transactions neither party has superior knowledge.
Most swaps and other OTC derivatives are relatively simple transactions for which the terms and conditions are easily understood by both the dealer and the end user involved. Even swaps with more complicated payment formulas typically are thoroughly examined and understood by both parties before a transaction is agreed to.
Neither party, of course, could be deemed to have superior knowledge of the most important determinant of the performance of such transactions, which is future movements in interest rates, currency rates, commodity prices, or equity prices. There cannot be disclosure of that which is not known.
End users, therefore, should not take false comfort that Judge Feikens' decision will provide an effective remedy for any swap that ends up being unprofitable.
It only applies to a very limited category of transactions and situations where the dealer "knows" that the end user "is acting on the basis of mistaken knowledge."
Rather - as a matter of prudent conduct and good management - end users would be well-advised to make sure that they understand all their swaps and other OTC derivative transactions before they enter into them.
The hazards and burdens of litigation are a risky, inefficient, and imprudent substitute for clarification of relationships before dealing and the careful management of financial risk.
Mr. Cunningham is a partner of Cravath, Swaine & Moore in New York. He regularly represents dealers in, and end users of, derivatives and serves as counsel to the International Swaps and Derivatives Association. The views expressed in this article are his own.
