for BT to “lock in” rates on all of its leveraged deals, it had accumulated $195 million in additional financing costs. The company subsequently took a $157 million pre-tax charge on the transactions and filed a lawsuit against BT for failing to disclose important information related to the deals (such as how to compute the payout profile of the leveraged swaps under various scenarios), misrepresenting the risk of the transactions and breaching the fiduciary/advisory relationship. The court case was accompanied by the disclosure of embarrassing material from the BT trading floor tapes, which reflected “aggressive” sales practices and attitudes by select BT employees. The case was settled out of court prior to judgement, with P&G agreeing to pay BT only $35 million of the $195 million due under the derivative contracts. As above, a financial provider must be aware of the financial sophistication of its customer, its motivation for entering into particular types of transactions and whether these are truly suitable. It also highlights the importance of running hypothetical stress scenarios that demonstrate the financial gain or loss that a client could sustain if the unthinkable actually happens (e.g. a 300 basis point move in interest rates in 12 months).
4.1.3 Sumitomo Corporation
Sumitomo Corporation, a large player in the global metals market, built a considerable trad- ing capability in the early 1980s under head trader Yasuo Hamanaka. Hamanaka became so successful at trading in the copper market that Sumitomo gained a reputation as one of the savviest and most powerful copper dealers in the world. In fact, as Hamanaka’s influence grew, he became known as “Mr 5%” for routinely being able to control 5% of the global copper market (trading primarily through the London Metal Exchange (LME), the world’s largest forum for listed copper trading). By all accounts, Hamanaka actually posted strong profits for the company between 1991 and 1995; thereafter, he appears to have posted profits only by manipulating the market and hiding losing trades. Hamanaka’s apparent success allowed him to remain in his trading position for many years (a process that is contrary to the per- sonnel rotation schemes practiced by most Japanese firms). Thus, over a period of years he built a team of copper traders around him and gained control over all front- and back-office duties.
Global copper prices finally weakened in early 1996, as years of copper oversupply over- whelmed demand. At that point Hamanaka, who had successfully manipulated copper prices for at least six years (and perhaps as long as 10 years), had a very large long position in both actual physical copper as well as derivative contracts based on the price of copper. As his attempts to drive market prices became more obvious internal company auditors, as well as US and UK regulators, began investigating his activities. Hamanaka was soon “promoted”
out of the copper trading department. Hedge funds and other speculators, recognizing that Hamanaka’s “promotion” meant irregularities, quickly drove the price of copper down (push- ing it from $2700 to $2000/ton in just four weeks!). As the internal investigation unfolded, it became apparent that by controlling trading and back-office processes (including various unau- thorized and unreported accounts) and manipulating prices on the LME, Hamanaka was able to post fictional profits. He was also aided, wittingly or unwittingly, by several large international banks, which supplied Sumitomo with generous credit lines to meet LME margins. Sumit- omo initially declared $1.8 billion of losses from illegal trading – equal to approximately 10% of its equity – and eventually upped the figure to $2.5 billion. In 1999 the company decided to sue JP Morgan Chase, Merrill Lynch, UBS and Credit Lyonnais for $1.7 billion,
claiming they knew, or should have known, about Hamanaka’s illegal trades. Several banks pleaded “no contest” and settled the matter out of court (including Merrill Lynch, which paid
$275 million and JP Morgan Chase, which paid $125 million). This example illustrates the need for financial providers to ensure that their clients are duly authorized to deal, and that the most senior managers within the client organization sanction any potential financial engi- neering transactions. It also points out the need for managers at financial providers to review the activities of their own salespeople (who obviously get paid for the business they bring in);
while not foolproof, it can help ensure that everything being done with a client is prudent and
“above board”.
4.1.4 Prudential Securities
As noted above, suitability issues can also affect retail customers who may, knowingly or unknowingly, invest in securities that are inappropriate in terms of potential risk. Prudential Securities, a subsidiary of US insurer Prudential Insurance, paid a heavy price for not exercis- ing proper care in selling $8 billion worth of risky limited partnerships. From the early 1980s to 1990s Prudential’s salesforce sold its retail clients units (e.g. shares) in approximately 700 limited partnerships that invested in a range of assets, from residential and commercial prop- erties to energy projects. Most of the units were illiquid and speculative, with large amounts of credit and market risk. As one after another of these partnerships soured, irate clients took le- gal actions against Prudential on various grounds: lack of proper disclosure, misrepresentation of risks/returns and liquidity, and misvaluation of investments. The firm was investigated on criminal grounds and found guilty of fraud and negligence (though it escaped a criminal indict- ment). Prudential Insurance was ordered to establish a client restitution fund that eventually topped $1 billion, and restructured its securities subsidiary with new management and controls.
This example illustrates the need for financial organizations to ensure that products aimed at individual investors are truly appropriate (with prudent amounts of risk) and accompanied by full and accurate disclosure of the potential downside that might be caused by poor perfor- mance, credit, market or liquidity events. It also highlights the need for the strictest possible financial reporting controls so that investors receive regular, and proper, valuations.
Many other disputes between clients and financial providers have arisen over the past few years; Table 4.1 summarizes some of these incidents.
Table 4.1 Client/financial provider disputes
Financial provider Dispute
Prudential Securities Risky limited partnerships targeted at retail investors Bankers Trust Derivatives with Gibson Greetings, Air Products and
Chemicals, Sandoz, Jefferson Smurfit, various Asian clients Deutsche Bank Swaps with South East Asian companies (Malaysia, Thailand)
JP Morgan Swaps with Korean companies
Merrill Lynch Options with Kingdom of Belgium
Various international banks Credit lines for Sumitomo Corporation’s LME derivatives Various international banks Repurchase agreements and other leveraged instruments with
Orange County
Various UK and international banks Swaps with UK local authorities