Bankers Trust: Learning from Derivatives*
Bankers Trust (BT) was one of the most powerful and profitable banks in the world in the early 1990s. Under the stewardship of Chairman Charles Sanford, Jr., it had transformed itself from a staid commercial bank into “a highly-tuned manufacturer of high-margin, creative financial products—the envy of wholesale bankers.”1 BT prided itself on its innovative trading strategies, which used derivatives to manage risks; its performance-driven culture; and its profits: the bank made a profit of over $1 billion US in 1993.2
Key to BT success was the dominance of its business in derivatives—contracts in which companies make payments to each other based on some under-lying asset such as a commodity, a financial instrument, or an index.3 The value of the payments—and thus the contract—is derived from those assets. Companies can use derivatives to lower financing costs, manage risk, or speculate on interest and currency rates. It is estimated that almost $400 million of BT’s 1993 profits came from its leveraged derivatives business.
Derivatives, with their high margins, held a preeminent position with BT management, with their fervent focus on the bottom line. At BT, each product and each trader was given a value that was based on what income the product or trader could bring the firm.1 The bank’s intense focus on the bottom line decreased attention on products and services which had low margins but which fostered and nurtured client relationships. BT was known for courting customers only insofar as they would buy high-margin products.1 In 1990 Charles Hill, former co-head of merchant banking, left with thirty members of his department because he saw no room at BT for offering clients impartial financial advice and deal structuring. One source within the company explained: “we got rid of the nurturers and builders—the defensive guys—and kept the offensive guys.”1 Those who remained describe a firm driven by intense internal rivalry, endless politicking, and discussions about profit and losses. They describe a “coliseum” mentality at the top level: “we look on while the guys are out there fighting the lions.”1 What remained was a bank where the customer’s interests appeared to come second to the bank’s.
It was within this context that BT, once one of the most powerful banks in the world, was disgraced by a series of highly publicized lawsuits brought forth by several of its clients in 1994 and 1995 over losses they incurred as a result of derivative products sold to them by BT. The clients contended that BT sold them the derivatives without giving them adequate warning and information regarding their potential risks. BT countered that these derivative deals were agreements between the bank and sophisticated clients who were now trying to escape from their loss-making contracts by crying foul.2 At issue was whether the clients were naïve and should have known what they were getting into or whether BT deliberately deceived them (p. 110).4
There were more than half a dozen companies that suffered losses as a result of derivatives due to BT’s allegedly fraudulent sales practices (Appendix 1), but the Procter & Gamble (P&G) case is representative of the other cases.
Appendix 1: Companies That Procter & Gamble Says Lost Money on Derivatives Due to Bankers Trust’s Allegedly Fraudulent Sales Practices
COMPANY LOSS (MILLIONS $US)
Procter & Gamble 195.5
Air Products 105.8
P.T. Adimitra Rayapratama 50.0
Federal Paper Board 47.0
Gibson Greetings 23.0
Equity Group Holdings 11.2
Jefferson Smurfit over 2.4
Source: Business Week, October 16, 1995.
The relationship between P&G and BT’s derivatives unit was established in January 1993 when the company set up a broad agreement with the bank for derivatives contracts. In November 1993, P&G agreed to buy a leveraged derivative product; P&G would make large profits if interest rates decreased and would lose money if interest rates increased. Leveraged derivatives products are a complex type of derivative, and their value can fluctuate to a greater degree than ordinary derivatives. The derivative worked fine at first, and P&G was sufficiently satisfied to agree to a second leveraged derivative contract in February 1994. However, interest rates began to rise that same month, significantly increasing P&G’s payments to BT.
It is unclear whether P&G knew the cost of getting out of the contract, and P&G has since acknowledged that its internal procedures were not followed when it agreed to this derivative. P&G claimed that Bankers fraudulently induced it to buy complex derivatives, misrepresented their value, and then induced P&G to buy more for alleged gains or to staunch losses. However, P&G appeared to be an active market player. It had $5 billion in long-term debt, and its treasury managed a large, sophisticated portfolio of derivatives. P&G has acknowledged that its internal procedures were not followed when it entered into the derivatives contracts in November 1993. Ed Artzt, P&G’s CEO, said the executives who bought the derivatives ignored policies against such speculation and were “like farm boys at a country carnival.” His treasurer, Ray Mains, didn’t read the contract he signed, didn’t ask the right questions, and didn’t assess risk by seeking outside help. Artzt also said Mains “failed to tell his boss when he knew he had a problem, … delayed while losses piled up, … and misled his boss into believing the loss was much smaller than it was.”5 P&G’s CFO, Erik Nelson, relied on Mains instead of getting outside advice and did not inform Artzt or the board of the problems with the deal.
P&G’s court filings include taped conversations that took place at Bankers Trust. In November 1993, Kevin Hudson, a managing director and salesman on the P&G deal, told his fiancee that the transaction would bring BT a profit of $7.6 million. She asked, “Do they understand that? What they did?” He replied, “No. They understand what they did but they don’t understand the leverage.” She warned Hudson that the deal would blow up on him. He replied, “I’ll be looking for a new opportunity at the bank by then anyways.” When the Fed raised interest rates in February 1994, P&G lost $157 million and when asked if “they were dying” Hudson replied, “They don’t know.” He was even then trying to sell P&G a second leveraged derivative and said, “Let me just get the deutsche mark trade done first; then they can ask.” By April 12 that year, P&G announced a $157 million derivatives bath. Hudson’s bonus for 1993 was $1.3 million. (He and his fiancee were married on November 5, 1994, live in London, and are still working for BT.5)
P&G contended that, when it asked for an explanation of the costs, it learned that the bank was using a proprietary model to calculate the costs which it would not share with P&G.4 P&G alleged that, in April, BT gave the company charts which showed that it would have had to pay a penalty to get out of its November contract almost from the day it was initiated.
Further evidence points to taped conversations between BT employees in which a BT salesman, discussing P&G’s decision to enter into the November contract, says “we set ‘em up.”4* P&G finally locked in interest rates on both the derivatives; however, it claimed that by the time it finished doing so, its financing costs were $195.5 million higher than they should have been (p. 110).4
P&G asserted that BT employees were trying to deceive it from the day the derivatives contract was initiated. As evidence, P&G points to a taped conversation between Bankers employees about the November contract where one asks: “Do they [P&G] understand that? What they did?”4 The other employee replies: “No. They understand what they did but they don’t understand the leverage, no.”4 The first employee then says: “But I mean … how much do you tell them. What is your obligation to them?”4 The second employee responds: “To tell them if it goes wrong, what does it mean in a payout formula …”4 P&G sued BT in October 1994, alleging that the bank “deliberately misled and deceived it, keeping the company in the dark about key aspects of the derivatives the bank was selling (p. 106).”4
BT countered that P&G was an active and sophisticated player in the financial markets and knew how its derivatives would perform. In court filings, BT described P&G as “sophisticated, experienced, and knowledgeable about the use of interest-rate derivative contracts and the risks presented by those contracts (p. 109).”4 It added: “Although P&G would like this court to believe that it is a naive and unsophisticated user of derivatives transactions, the fact is that as part of its regular course of business and with authorization from top management, P&G’s Treasury Department managed a large and sophisticated portfolio of derivative transactions (p. 109).”4 BT asserted that P&G knew how the derivatives would perform and had included a taped conversation in its court filings in which a BT employee shows a P&G treasury employee how to calculate its rate on the November derivative.4 BT also produced evidence in court filings that P&G top executives blamed their own personnel for the investments. “Rather than putting its own house in order, and accepting its losses, P&G chose instead to bring this lawsuit (p. 111).”4
On September 1, 1995, P&G filed a motion in the U.S. District Court, which was approved, to add RICO (racketeer-influenced and corrupt organization) charges to the allegations against BT. A company found guilty of RICO charges is liable for three times the damages and plaintiff’s legal costs. Banker’s counter-filing called this “blackmail”, saying P&G was hoping to vilify BT by the sheer number of its charges.
The lawsuit was settled out of court in May 1996.
Bankers Trust: Learning from Derivatives*